THE BLOG
10/15/2014 10:51 am ET Updated Dec 15, 2014

Bankrupt Gambling

The bank gambling trade association and its regulators are giving each other high-fives over an agreement that supposedly makes it easier to bail out a failed mega-bank. Progress? If viewed from the vantage of an average taxpayer who finances bank bailouts, the progress is miniscule. And the circumstances that put this agreement barely into the "progress" column beg for far more ambitious reform.

Specifically, 18 of the largest global banks just agreed to wait about a day when one of them fails before pocketing the winnings from bets made with each other. Exactly how long the waiting period will be isn't clear. These bets are called swaps. The agreement about how bets are settled is governed by a master contract of the International Swaps and Derivatives Association (ISDA), which is the industry trade association.

Originally conceived as hedges, the way farmers lock in a price for commodities such as corn that hasn't yet been grown, harvested and sold, swaps have now been perverted into a $700 trillion racket largely patronized by banks. This high stakes game primarily plays out in what's called the over-the-counter (OTC) market. Ninety percent of the OTC bets are between banks themselves. In fact, four banks account for most of the bets in the U.S. banking industry. Real economy companies such as airlines or car manufacturers account for only about 10 percent of the OTC casino. Even mega-bank Wells Fargo, currently the most valuable bank on the US stock market, doesn't gamble nearly at the scale of its peers JP Morgan, Citigroup and Bank of America. In other words, if swaps are so useful to the economy, why doesn't Main Street account for most of them? And how can Wells Fargo be so successful a bank without a swaps portfolio that matches Citi's?

One enabler of this OTC swaps gambling has been the bankruptcy code. Normally, lenders must be wary of the entities to which they loan money because if a company declares bankruptcy, it may not repay the entire loan. Bankruptcy law outlines procedures for slicing up and doling out what's left of value in a firm. The first step is what's called a "stay" on payments.

The average liquidation in bankruptcy lasts more than 700 days before all claims are settled. But swaps gamblers don't have to wait for the liquidation process to play out so they are therefore guaranteed to recover their winnings. So one bank needn't worry if the bank it's gambling with is badly run. As one scholar soberly noted: "By privileging this class of creditors, these [bankruptcy] provisions reduce incentives to monitor counterparty risk, and thus magnified losses experienced during the recent financial crisis."

Why swaps gambling enjoys this privilege is a testament to bank lobbying, according to Duke scholar Prof. Steven Schwarcz, who has traced the devolution of bankruptcy discipline for the swaps market. Casino gambling on swaps probably shouldn't exist, let alone receive privileges in bankruptcy

The Lehman Brothers firm had some 900,000 swap bets open at the time of its bankruptcy. One reason for the mess caused by the Lehman bankruptcy is that winners collected their cash immediately, and losers waited until the bankruptcy court forced payment. The cash that evaporated through terminated swaps bets left less for Lehman's other creditors.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) law already provides that the US government can declare a short stay if it decides to step in and prevent a financial firm's bankruptcy, which might include a bailout. Among the problems of the current U.S. law is that it only covers U.S.-regulated banks. Where a U.S. bank makes a swaps gamble with a foreign firm, that foreign firm can still immediately collect its winnings. The new ISDA stay agreement between the 18 largest banks is touted as progress because it would apply to cross-border swaps. ISDA's announcement was welcomed by US regulators and the Federal Reserve Board called it "an important step."

However, others believe the short stay agreement will backfire. Trader Michael O'Brien of Eaton Vance said it would lead to "runs on banks" because "if I know a counterparty looks likely to default, I will want to close out my positions immediately before I am stayed."

Some believe the problem will just shift. Analyst Karen Petrou believes swap traders will move away from the banks covered by these rules to firms that aren't regulated banks that belong to ISDA. That could be a good thing since reducing swaps gambling at banks, especially mega-banks, might be a slight improvement for taxpayers if such gambling is contained to firms that won't require a bailout because they're not considered systemically important to our economy.

In the end, ending the swaps privileges in bankruptcy altogether would be real improvement. Congress could reform bankruptcy law or regulators could force banks to change their swap agreements. Existing provisions in Dodd-Frank empower the regulators to do just that. Dodd-Frank requires banks to prepare plans dubbed "living wills" that make bankruptcy possible. The government must find these wills "credible." None of the mega-banks have passed this test yet. When they do, that will be time for a high five.