We Modernised Ourselves into this Ice Age

By New York State Insurance Superintendent Eric Dinallo
Published March 30, 2009 on the Financial Times (UK)

Many compare this financial crisis to the stock market crash of 1929, but it is closer to the credit freeze and bank panic of 1907. We might have avoided the worst of the current troubles if we had not overturned laws adopted in response to earlier crises. We should have placed more value on the hard-earned lessons of the instability that comes from unregulated markets and gambling on securities prices.

The bank panic of 1907 is remembered for J.P. Morgan forcing all the bankers to stay in a room until they agreed to contribute to fixing the crisis. What has been forgotten is one major cause of the crisis ­– unregulated speculation on the prices of securities by people who did not own them. These betting parlours, or fake exchanges, were called bucket shops because the bets were literally placed in buckets.

The states responded in 1908 by passing anti-bucket shop and gambling laws, outlawing the activity that helped to ruin that economy.

Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration.

What has that got to do with today’s crisis? Credit default swaps are the rocket fuel that turned the subprime mortgage fire into a conflagration. They were the major cause of AIG’s – and by extension the banks’ – problems. AIG Financial Products, the unit that sold almost $500bn (€379bn, £353bn) of them, may therefore be viewed as the biggest bucket shop in history.

Credit default swaps started out as essentially an insurance policy. If you owned a bond in a company and were concerned it might default, you bought the swap to protect yourself. Literally, the buyer swaps the risk of default with someone else. Banks bought them to reduce the amount of capital they were required to hold against investments – in other words, to avoid regulation. Because they owned the swap, banks claimed they no longer had the risk of a default of the bond. Others bought swaps without owning the bond to place a bet on a company’s future.

But there was serious concern that swaps violated the old bucket shop laws. Thus, the Commodity Futures Modernisation Act of 2000 exempted credit default swaps from these laws. The act also exempted them from regulation by the Commodities and Futures Trading Commission and the Securities and Exchange Commission. Unregulated, the market grew enormously. Thus, one of the major causes of the financial crisis was not how lax our regulation, or how hard we enforced, but what we chose not to regulate.

Indeed, what we decided was old fashioned and in need of modernisation was, in fact, an effective check on an activity that for 100 years had been illegal, for good reason. As a result, we modernised ourselves into this ice age. 

We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency.

The fear in 2000 was that if we regulated credit default swaps and required holding sufficient capital, the market would go where unregulated sellers could make more money. We forgot that the biggest competitive advantage of the US financial system has always been safety, security and transparency. If we destroy that perception, the long-term cost to our society is incalculable. What did we learn at the start of the last century that we then disregarded either through amnesia or hubris? What lessons, now learnt twice, can be gained from all this?

There are basically four ways people hand over money to financial institutions: 1. Bank deposit accounts. You deposit your money and the return of principal and interest is guaranteed. Banks are required to hold enough capital to deliver on that promise. 2. Insurance. If you suffer a loss, you are guaranteed recovery. Insurance companies are required to hold capital to meet that guarantee. 3. Gambling. If your bet wins, you are guaranteed your winnings. Casinos and racetracks are required to hold enough funds to ensure payouts. 4. Investment. There are no guarantees when you invest in a stock or a bond. You could lose everything. Appropriately, investment bank capital requirements are much lower. The first three categories contain guaranteed payments against future events; the fourth is merely aspirational. 

A key lesson of this crisis is the danger of insufficient capital and the risks of alchemy. 

 We thought we could use alchemy to create a perfect fifth category that allowed guarantees supported by little or no capital, and that would produce hefty profits with no real risk. Instead, we re-created the old bucket shop gambling parlours on steroids and another credit crisis. Financial products should be seen as belonging in one or another of those four categories and regulated appropriately. If there is a guaranteed outcome, then the guarantor must hold sufficient capital to make good on that guarantee. A key lesson of this crisis is the danger of insufficient capital and the risks of alchemy.

Credit default swaps must be regulated and sellers must be required to hold sufficient capital. That will make them more expensive, but it will mean the guarantee has real value.

Does requiring adequate capital mean the end of financial innovation? Of course not, it just means that most institutions will operate with less leverage. Risk and reward are integral to capitalism. But innovators should risk their own capital, not the entire financial fabric. Setting that balance is where effective regulation comes in. 

No one should ever again get to bet the store called the Entire American Economy. And certainly do not assume we are smarter than folks 100 years ago.

 In sum, if you offer a guarantee – no matter whether you call it a banking deposit, an insurance policy, or a bet – regulation should ensure you have the capital to deliver. If you offer investments, be transparent, but buyer beware. No one should ever again get to bet the store called the Entire American Economy. And certainly do not assume we are smarter than folks 100 years ago. As Mark Twain is supposed to have said, history may not always repeat itself, but it sure rhymes.