I am an admirer of Frank Partnoy, now Professor of Law and Finance at the University of San Diego. His book Infectious Greed (2003) revealed  financial thievery, scams and chicanery on Wall St. during the previous 15 years. Had we read it carefully and believed it, we would have sold all our assets at once, well before the 2007-9 crisis.  

Partnoy was recently interviewed by CBS’ 60 Minutes team. His ‘take’ on the underlying cause of the global financial crisis is stark and simple. It is this: America legalized and deregulated gambling — but only on Wall St. Elsewhere gambling is closely regulated, and on-line gambling is still not legal. The gambles Wall St. took were concealed, huge and irresponsible. When they lost, so did all of us. 

How and why did this happen? I’ve written about this in detail in our forthcoming book*. But Partnoy explains it very simply.   

In the bubble leading up to 1907 (see my earlier blog on this), Wall St. was covered with ‘bucket shops’ — places where you could place a bet on a stock without actually buying that stock. Since stocks were always rising, mostly you won.  So the bucket shops pulled in money like a huge vacuum cleaner. The Financial Collapse of 1907 was caused in part by bubble speculation driven by these bucket shops. After the crisis, tough legislation made such bucket shops illegal — permanently. This legislation also banned anything that resembled financial gambling…

….Until the year 2000. In its dying breath — the last day of the last session of the 106th Congress — the Commodities Futures Modernization Act was passed. Recall, Clinton was still President, but Congress was Republican and pro-free market. Page 262 of the Act, notes Partnoy, banned state governments from enforcing “bucket shop” laws against financial gambling. The same Act, I note in my book, made “swaps” and “derivatives” immune from any form of government regulation, including collection of statistics.  

Now, credit default swaps (CDS, insurance against bond default) had been invented in 1994. They were called ‘credit default insurance’. Quickly the name was changed to ‘credit default swaps’, because swaps were not subject to regulation. (A credit default swap is in no way anything resembling a swap). After the  2000 Act passed, legalizing CDS gambling boomed, growing from $100 b. to a market totaling over $50 trillion (four times the US GDP). The bucket shops were back — only now, they were global and a million times bigger and more toxic. Blame Clinton and Greenspan, notes Harvey Goldschmidt, a former Securities Exchange Commission lawyer. Clinton permitted this. And Greenspan (Fed Chair) flooded the world with money to facilitate it. 

Three companies — Bear, Stearns; Lehman Bros.; and AIG — made money on CDS’s, because in boom times, no bonds are in default, and the two percent premiums (a CDS cost roughly 2% of the face value of the bond) are licenses to print money. Their senior managers got enormous bonuses as a result. But when the security-backed mortgages collapsed, these companies could not pay their debts. Bear Stearns was acquired for pennies on the dollar, Lehman went bankrupt and AIG was bailed out by the US Treasury to the tune of a staggering $180 b. 

Partnoy notes that many people became hugely wealthy by buying CDS’s, betting the bonds would collapse. They prefer, for obvious reasons, not to be widely known in public. Some were Saudis. Note that a CDS had nothing to do with insurance. It was a pure gamble. One hedge fund manager who invested in CDS’s got $3.4 billion (that’s billion, not million) in fees and bonuses in a single year.

How many senior managers in the financial services industry really understood the risks and intricacies of these CDS roulette wheels?  

“At senior levels, I think they were only vaguely understood,” notes Partnoy.  

How bitter life must be for these Masters of the Universe, who in a split second went from hero to villain, over something that they did not fully understand or bother to understand. 
* S. Maital, D.V.R. Seshadri. Global Risk/Global Opportunity: Ten Essential Tools for Tracking Minds, Markets and Money. Forthcoming: SAGE 2010.