Misplaced Regulation

by Kevin D. Freeman on May 17, 2012

SHOULD CHILDRENS LEMONADE STANDS BE ILLEGAL?In our many briefings, we have warned against the secret weapons that can, have been, and are being used against our economy. We discuss things like Credit Default Swaps (CDS) and naked short selling as just a couple of examples. We point out that Credit Default Swaps were specifically exempted from ANY regulation until the recent Dodd-Frank law. And, Dodd-Frank regs haven’t really been written or enforced. Even when they are in place, many doubt the regs are properly aimed or can be effective.

Let’s not forget that George Soros himself said that short selling and Credit Default Swaps are what tanked Lehman and this is what tanked the economy. Warren Buffett called Credit Swaps “financial weapons of mass destruction.” They were not alone in the criticism. Yet, Credit Default Swaps were completely exempted from ANY regulation. Does that seem right? But it was. Read this:

“It’s legalized gambling. It was illegal gambling. And we made it legal gambling…with absolutely no regulatory controls. Zero, as far as I can tell,” from the New York Insurance Commissioner.

“Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure,” Cox told the Senate Banking Committee today at a hearing on the government’s $700 billion financial rescue plan. Lawmakers should provide the authority “to enhance investor protection and ensure the operation of fair and orderly markets,” he said.     from the former head of the SEC.

For those who are unsure exactly why CDS are a problem, let me ask a simple question. Would you be comfortable learning that lots of people you don’t know are taking out life insurance on your life? And if they could, wouldn’t you want someone….anyone to regulate it?

It might be helpful to realize that Credit Default Swaps are very similar to the Bucket Shop bets of the 1920s that almost destroyed the market. Consider this from Eric Dinallo in Financial Times (http://www.ft.com/cms/s/0/3b94938c-1d59-11de-9eb3-00144feabdc0.html#axzz1vBZGYjOq):

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.

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.

Here is why bucket shops were outlawed. It is easier to bet on failure and make that happen with illegal activity (theft, coercion, causing a labor strike, cutting off credit) than to bet on success and make that happen. What they discovered 100 years ago is that unregulated bets against a company end with a greater level of failures. So they regulated bucket shops out of existence. About a decade ago, they were revived in the form of Credit Default Swaps and left unregulated. The market has been suffering ever since.

Now, contrast the fact that these financial WMDs were left unregulated. But, at the same time we have been busy over-regulating things like kid’s lemonade stands, bake sales, ice cream parlors and farm-fresh food. A few links to stories that make the point are shown below. When you read them, keep in mind that we oppose the ridiculous “nanny state” rules. But, we do believe that maybe a little bit of regulation of financial WMDs capable of causing a new Great Depression might just make a little bit of sense.

Feds cracking down on lemonade stands

Utah School Fined $15,000 for Accidentally Selling Soda During Lunch

Ice Cream spot shut down by environmental police

Feds shut down Amish farm for selling fresh milk

Food safety paranoia hits Nevada farm-to-table event

I Tried to Open a Lemonade Stand

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