By Brian McCall
The Daily Record Newswire
One of the sticking points in the recent negotiations between the House and Senate over the Financial Regulatory Reform Bill involved a proposed ban of naked credit default swaps. These were not obscene in the usual meaning of this word. A credit default swap is a contract where the seller agrees to pay the buyer a fixed amount if a defined credit event occurs on a reference security. For example, in exchange for a payment of $10 million, a seller might have to pay a buyer $100 million if a particular series of General Motors bonds defaults. A naked CDS occurs when the buyer does not actually own any of the reference security (the particular GM bond).
Although a CDS can be used like insurance against default risk and as a way to hedge other exposures, one can be used to make bets or to merely gamble. A naked CDS is identical to betting on the Oklahoma City Thunder losing a playoff game. The major difference is that such bets are not usually made in the tens of millions of dollars. Most agree that naked credit default swaps played a significant role in the collapse of AIG.
As a result of concerns that state contract law could invalidate naked credit default swaps as gambling contracts contrary to public policy or contravene state bucket shop laws, the federal government pre-empted all such laws in 2000. Several senators called for a reversal of this federally sanctioned gambling as part of the regulatory reform. The compromise reaffirms the status quo. The bill still excludes state law from restricting these legalized gambling products. The bill does deny any future federal bailouts or assistance to commercial banks that engage in this form of gambling directly.
Such a prohibition is virtually worthless. Commercial banks that want to roll the roulette wheel in this potentially lucrative betting can do so if they conduct this activity through a separate subsidiary. This merely ups the cover charge to enter the financial casino by increasing capitalization costs.
The ban on bailouts is likely an empty threat, as well. The past two years proved the hypothesis of “too big to fail” a reality. Wall Street banks obtained multibillion-dollar bailouts by using the threat of a total economic collapse. The legislative prohibition on bailouts for banks that gamble directly can be overturned by a future Congress. Faced with the economy held hostage again, will the politicians abide by this restriction? I wouldn’t bet on it!
Notwithstanding the thousands of pages of the reform bill, the deck is ready to be dealt again. A case can be made for some legitimate uses of these products.
Then again, a local hot dog seller might argue that betting on the outcome of the baseball playoffs is a legitimate hedge.
There are fine distinctions that need to be made, the kind of distinctions state common law courts were making for over a century before the 2000 pre-emption. Instead of returning to such a regime, the Congress is willing to let the betting go on more or less as usual. The experts can start formulating odds on the next naked CDS-instigated collapse. Any takers?
Brian M. McCall is an associate professor at the University of Oklahoma College of Law.
