- The Washington Times - Tuesday, September 14, 2010

OPINION/ANALYSIS:

ASPEN, Colo. | Two years after the 2008 credit crisis tipped our economy into recession, many people still don’t understand what went wrong. That’s because most experts don’t explain the crisis in simple, straightforward English. Put simply, the crisis was caused by derivatives. And derivatives became a problem because Congress decided in 2000 to change the law and abandon long-standing conservative principles for dealing with speculation.

Derivatives are often called “assets,” “products,” “innovations” and even “investments.” These labels are misleading. The simplest and most accurate way to describe derivatives is, quite literally, as bets. Two parties make different predictions for the future of some bond, currency, interest rate or commodity price. When the future arrives, the party who predicted wrongly pays money to the party who made a better prediction. Far from being innovations, derivatives have been around since the Babylonians used them to bet on the fates of trading caravans.

It’s important to understand that this sort of commercial betting can be economically beneficial when used to hedge against real, pre-existing risks. For example, when you buy homeowner’s insurance, you are betting an insurance company that your house will burn down. If your house burns, you win the bet, offsetting your loss. Because hedging is so useful, for centuries the law has honored and enforced derivatives used for hedging, calling them “insurance.”

But the law traditionally adopted quite a different attitude toward speculative derivatives bets between parties who both lacked an “insurable interest” in the thing they were betting on. In the eyes of the law, speculative derivatives betting was just gambling. Unlike hedging, which reduces risk, gambling increases risk. Instead of two people who each have money, you end up with one with lots of money and one who may be bankrupt. For this and other reasons, healthy economies limit gambling. In ancient Rome, gambling was permitted only during the week-long festival of Saturnalia.

U.S. law historically discouraged gambling in a more subtle fashion. The law permitted commercial gamblers to make bets with each other, but refused to let them use public courts to enforce their bets. “Difference contracts” (as 19th-century judges called derivatives) were legally unenforceable. This rule of legal unenforceability drove would-be derivatives gamblers to form private gambling clubs, clubs with owners who had both the motive and the sophistication to ensure the derivatives gamblers made good on their bets and didn’t get in over their heads. Thus private options and future exchanges were born. They did a very nice job, for well over a century, keeping derivatives speculators from causing problems for the rest of us.

Unfortunately, Congress decided to abandon this time-tested system in 2000 when it passed a statute called the Commodities Futures Modernization Act (CFMA). (If Congress decided to make murder legal, it would probably pass a Homicide Modernization Act.) In one fell swoop, the CFMA reversed over a century of American business law by declaring off-exchange speculative derivatives bets by banks and other large financial institutions to be legally enforceable. Not only could banks now gamble off the exchanges, they could borrow to gamble as well. The market for off-exchange derivatives exploded, from about $80 trillion in 1999 to more than $600,000 trillion by 2008. (If murder were legalized, we could expect a similar expansion in the market for murder.) Inevitably, some of the derivatives gamblers - Bear Stearns, Lehman Brothers, AIG - lost big. The credit crisis followed.

Once the real cause of the 2008 credit crisis is made obvious, the easy - and conservative - solution to derivatives gambling becomes obvious as well. Rather than empowering government bureaucrats to regulate off-exchange derivatives as they see fit, as Congress has in the 2010 Dodd-Frank bill, we could return to the time-tested system of allowing courts to recognize true insurance contracts while refusing to enforce purely speculative derivatives bets made outside the watchful gaze of a private exchange. This approach is easy and inexpensive. Better yet, history and experience teach that it works.

- Lynn A. Stout is the Paul Hastings professor of corporate and securities law at the University of California at Los Angeles School of Law.