You may recall that credit default swaps were the prime instrument in the nearly $200 billion collapse of AIG, which had to be bailed out by the U.S. government. AIG, the world's largest insurance company, in effect wrote insurance against sub-prime securities going bad, but without setting aside reserves against that risk.
Reserving against possible loss is the fundamental pillar of the insurance business. AIG could get away with breaking that rule because industry has successfully lobbied for a loophole holding that a swap was not quite insurance, not quite a security, not quite illegal gambling -- it conveniently fell between the cracks.
The Dodd-Frank Act made an effort to lay down general principles for regulation of swaps, but they are being gutted day by day as the financial industry lobbies over the details of Dodd-Frank's implementation. Do you find that issue arcane and boring? Good! This is just how the bankers like things.
Now swaps have reared their ugly heads once again in the effort by the European Union to head off a Euro collapse. Not only does Greece owe some 340 billion euros, hundreds of billion more euros worth of swaps have been written by some of the same banks to insure that debt against default. In effect, the banks are insuring each other's debt -- kind of like insuring yourself.
And the bankers lobby -- the International Swaps and Derivatives Association -- has taken the bizarre position that the proposed 50 percent reduction in Greek debt is not a "default event," a term that did not even exist two decades ago.
What, pray tell, is a default event? It's a failure to pay part of the debt that one owes -- that somehow does not trigger payments under credit default swaps. In other words, you lend a friend some money, and he promises to give you his car if he fails to pay. Now he says he can only pay you back half of what he owes. What about the car? Too bad for you, he's making a partial payment. He keeps the car, too.
And who gets to decide what's a "default event?" The regulators, right? Noooo, the same bankers' lobby, the International Swaps and Derivatives association. It's another case of privatized regulation. The New York Times had a terrific explainer piece on this by the irreplaceable Louise Story and Louise Creswell on Friday.
So basically, the bankers are holding a gun to the EU and saying, if you expect us to take a hit as bondholders, forget about us taking a second hit as writers of default insurance in the form of swaps. Even though this insurance was a clear contract, let other bondholders take that hit.
The only useful fallout from all this is that European leaders -- who are bailing out the banks via the European Central Bank and a new special bailout fund -- are getting more than a little disgusted with the bankers. Germany, for instance, took a huge domestic political risk in supporting a much larger bailout than most German voters supported.
Now, the influential German Foreign Minister Wolfgang Schauble has lent his voice to those supporting a financial transaction tax to discourage speculative trading.
The financial transaction tax has become a useful symbol of the need to rein in the banks. Its enactment would mark an important turning point -- it would show that the power of the banks can be broken. And if the US government keeps opposing it, the EU should enact it unilaterally -- every global bank does business in Europe.
But such a tax would be only a small first step. Banks would still invent exotic instruments and trade them; they'd just have to pay a small tax.
It's time to simply abolish credit default swaps and similar exotic, impenetrable, essentially unregulated securities. They add nothing to economic efficiency, they line bankers' pockets, and they add massively to global financial risks. Swaps were only invented in the 1990s. The world got along beautifully -- much better in fact -- without them.
Before swaps, investors were perfectly capable of evaluating risks -- and there was less systemic risk to evaluate.
Bankers still rule. Citigroup just agreed to pay a modest $285 billion fine to settle the SEC's case that it systematically misled its customers by creating junk that Citi officials knew to be toxic and then unloading it on unsuspecting buyers. The SEC concluded that this was merely "negligence," when it was clearly deliberate and criminal fraud.
But the people running the country would rather single out the occasional high profile mogul who engages in insider trading, and use him for an isolated perp walk, rather then indicting the corruption of the entire system.
So feeble and inconclusive is the so-called Volcker rule prohibiting banks from trading for their own accounts that the process of defining it has required the parody of bureaucratic hair-splitting. The Wall Street Journal has had a field day making fun of the Keystone Kops trying to figure out what proprietary trading means.
And in this case the Journal has a point (even a stopped clock is right twice a day). It is a travesty that President Obama's advisers came up with the gimmick of naming the ban on proprietary trading for Paul Volcker, who actually supports a return to the Glass-Steagall Act cleanly separating commercial banking from investment banking. That clear, bright line doesn't require Keystone Kops. It is also fiercely opposed by Tim Geithner and the other banker cronies in charge of "regulating" banks.
Did you know that nothing in the Volcker rule prohibits Bank of America from transferring its entire portfolio of derivatives, much of which are underwater, from the investment bank that it owns, Merrill Lynch, to its government-insured commercial bank? If we had the Glass-Steagall Act, Bank of America could not own Merrill Lynch at all.
The entire banking system is overdue for a drastic simplification. Bring back Glass-Steagall. Ban credit default swaps outright. Get rid of other whole categories of exotic derivatives. Put banks back in their legitimate business of evaluating risks and then holding onto them, rather than passing the hot potato to someone else. We need simple bright lines that don't require thousands of pages of rules.
Elizabeth Warren, in the original version of the financial consumer protection bureau, proposed that no new financial product could be offered for sale until it could be proven non-toxic.
All this would require a revolutionary power shift. Sending some high profile banksters to prison would be a good start. Even though the SEC keeps taking a dive, New York's new crusading Attorney General Eric Schneiderman may yet find a way.
The Occupy Wall Street protests are already helping to promote this power shift. No reform worthy of the name will be forthcoming until the political system begins taking on the bankers.
This article is part of a series of articles on Seeking Alpha on Fixing Wall Street - a response to the Occupy Wall Street protests. Other articles include: