Many credit default swap hedges could have been prosecuted as insurance fraud … had they been regulated as insurance. (More)

ECONned, Part III: Insuring Financial Stability (Non-Cynical Saturday)

This week Morning Feature considers Yves Smith’s 2010 book ECONned: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism. Thursday we looked at the economic theory that enabled the Great Recession. Yesterday we examined how blind faith in that theory led to deregulation, looting, and the shadow banking system collapse. Today we conclude with Smith’s proposed remedies and our ideas for talking with median voters like our archetypal Fred.

Yves Smith is the founder of Naked Capitalism and has over 25 years experience in finance. A graduate of Harvard College and Harvard Business School, she has worked in corporate finance for Goldman Sachs, was the head of mergers and acquisitions for Sumitomo Bank, and currently heads Aurora Advisors in New York City. She has written for The New York Times, The Christian Science Monitor, and several other print and online publications.

The Story of Shady Eddie

Shady Eddie’s business card says he’s an electrician, and he is, sort of. Most electricians’ make a tough living, but Eddie and his bosses are raking in the dough. What’s their secret?

For starters, he uses complex, ‘innovative’ wiring schemes that use fewer and cheaper materials. Eddie’s bosses don’t understand his wiring schemes, but they’re making money so they don’t look too hard. City code enforcers don’t understand Eddie’s work either, but his company’s fees pay their salaries so they sign off on the permits. He also gets do to the rewiring when customer have problems, because no one else knows how to fix his work.

But even cutting corners on materials and getting the rewiring jobs aren’t Eddie’s real business secret. He knows that, sooner or later, at least some of the buildings he’s wired will have electrical fires. So he buys fire insurance. He makes a nice profit on the initial installations, gets paid again on the rewiring jobs, and gets yet another payday when the insurance check comes in.

Of course, Shady Eddie is only an electrician, so once the city catches on to him he’ll be charged with insurance fraud, at the very least. If only he’d become an investment banker instead….

Why They’re Not In Jail

Yves Smith explains that credit default swaps – the highly-leveraged bets that exploded the global economy in 2008 – are basically insurance policies against the failure of an underlying derivative. Many traders who set up those credit default swaps on mortgage-based derivatives knew the housing bubble would burst soon. In fact, many were structured so the trader stood to profit most when homeowners defaulted and the credit default swaps paid off. Like Eddie’s ‘creative’ wiring schemes, the mortgages were set up to fail, providing refinancing fees for mortgage brokers and bonuses for traders packaging those mortgages into derivatives. And as with Eddie’s scam, the traders convinced companies like AIG to guarantee credit default swaps if the mortgages failed.

But unlike Eddie, those credit default swaps were not regulated as insurance policies, so the traders weren’t committing insurance fraud … at least not under the law.

Shining a Light on Shadow Banking

Changing the law to regulate credit default swaps as insurance policies – not reinstating Glass-Steagall or breaking up ‘too big to fail’ banks – is Smith’s most compelling reform proposal. She concedes that credit default swaps are now so central to the ‘market-based credit’ model that the swaps cannot be shut down. But they can and must be regulated, including rules that require those who buy or sell swaps to have an insurable interest in the derivative on which the swap is based.

Smith acknowledges that regulating credit default swaps as insurance policies would increase the cost of the swaps, thus increasing the cost of the derivative bonds being insured, thus requiring the bonds to pay and the lenders to charge higher interest rates. In plain language, regulating the swaps as insurance would make credit more expensive.

And that, Smith argues, would improve the stability of the global economy. Cheap credit allows too many investors to leverage too much speculation – and creates too many profits for too many bankers – based on too little real productivity. “Finance should be the handmaiden of business,” she writes, “and not its master.”

While Smith does suggest reinstating Glass-Steagall, her reasons are not the reasons you’ll hear in the progressive media. Small commercial banks can be as profitable as larger competitors, because the services they offer do not benefit much by economies of scale. But investment banks benefit greatly by economies of scale. To remain competitive in an international market, investment banks must be ‘too big to fail’ and backed by implicit government guarantees.

A new Glass-Steagall, Smith argues, would both encourage small commercial banks to thrive again and also allow the federal government to treat huge investment banks as public utilities, with what she calls “strict and intrusive” regulations on their risk-taking, accounting, and compensation practices. If investment banks require government support during market crises – and they will – then government must be able to limit the risks being underwritten by We the People.

Alas, Smith acknowledges that enacting these reforms will require both business and political leaders to abandon the myth of Marketopia. She does not believe that will happen until the ‘free market’ dogma has failed so completely that its manifest flaws can no longer be excused away. And on that point I disagree.

President Obama and several other Democrats like Elizabeth Warren are using their 2012 election campaigns to make a case for shared responsibility and regulated markets that allow capitalism to flourish. If we activists do our part to help – including telling archetypal Fred the story of Shady Eddie – polls show that President Obama, Ms. Warren, and other Democrats can win on that case and change our economic dialogue.

Realworldia is not as tidy as the precise formulas of Marketopia. But we live in Realworldia, and our political and economic systems must admit that.

+++++

Happy Saturday!