Professor James Galbraith, of the University of Texas, is a powerful speaker and writer/critic of recent economic thought.  Here is a devastating critique of what the financial sector actually did to the American taxpayer, made in a written statement to the Senate Judiciary Committee.

The concept of insurable interest is a critical, stabilizing component of finance.  Much of what the nation, and much of the rest of the globe, has suffered from the current recession can be traced back to where the lack of insurable interest created opportunities to take on excessive risk, and to speculate on securities.

Here’s a basic definition of insurable interest.

“INSURABLE INTEREST – A monetary interest in life, property or an event legally entitling a person or business to insure it. Unless the insured will suffer financially in the event of a loss, he does not have an insurable interest and is not legally entitled to insure that particular risk.”

This is why you cannot insure your neighbor’s house.  If the house burns down you will not be harmed and therefore you have no insurable interest.  The reason for this concept is pretty straightforward.  If anyone could buy a policy on any house then there would be an incentive to burn the house down and make money from a policy.  A situation not at all good for the real property owner or the insurance company that sold the owner a policy.  So one cannot buy such a policy unless one has an “insurable interest.”

That’s the property example.  But the concept also applies to bonds and stocks, which are a form of property the owner of which also has an insurable interest.

Let’s go back to the property example right now.  It used to be that commercial and savings banks sold mortgage loans which they held in-house.   This meant that the bank had an insurable interest in the property along with the property owner.  And often a bank would recommend, if not demand, that the borrower pay to insure their mortgage.   As someone with an insurable interest, the bank would like to have some insurance.  If the borrower did pay for this insurance, they’d get a lower interest rate from the bank — because the bank was taking less risk due to being insured.

There’s an old saying that “all politics is local.”  So it is with real estate, which is “local” as well.  Or at least it was.

Then Wall Street innovated and constructed asset backed securities, including those that contained retail mortgages.  Large investment banks (as opposed to the local commercial or savings banks) would buy mortgages from local bankers across the country and bundle them into one security, which they sold to investors including professional ones like mutual funds.  Local banks liked the idea because they were paid immediately for the mortgage and thus relieved of any risk.  They no longer had an insurable interest, in other words

So who now had an insurable interest instead of the local banker, and the property owner?  Technically the insurable interest passed through the investment bank on out to the individal investors in the asset backed security.  As a practical matter, however, this diffusion eliminated insurable interest.

With insurable interest thus eliminated there was no longer any restraint put on investors, or speculators for that matter.

Enter another “innovation” from investment banks:  Derivative securities based upon large mortgage pools.  The difference between these derivatives and the older asset backed securities was that a derivative could be sold many times over – far beyond the value of the underlying securities.   And with a synthetic derivative, the investment bank didn’t even buy mortgages, but rather “synthesized” a security which they promised would mimic the price action of a “real” mortgage pool.   This was called a “reference” portfolio of securities.  They were never bought.  All it took was a lawyer to form a corporation for the investment bank, said corporation being able to sell shares in this synthetic mortgage based security which didn’t own any mortgages.

Needless to say things got highly leveraged, and highly risky, because the restraint imposed by requiring insurable interest was destroyed.

The same type of derivative innovation has now been applied to bond markets, both foreign and domestic.

Speculators can now “bet” via derivatives on bonds that they don’t own.  There’s two sides to these transactions, one side is called a credit default swap (CDS) and the other side is called a credit default obligation (CDO).  The person buying the CDS is betting the bond will perform as advertised and thus retain it’s price, while the CDO buyer is betting the bond will fail, or at least look like it’s going to fail and the price does drop.  Investment bankers can match both sides without anyone actually owning the bond.  No one has an insurable interest here.  There certainly is an interest in the sense that depending upon the bond performing or not, one speculator or the other is going to either make, or lose, money.  But like the other derivates, the number of speculators, and the total amount of money “bet,” can go far beyond the actual value of the underlying bond.  This is a direct form of leverage, and a direct extension of risk.

In both mortgages, and bonds, derivatives unrestrained by insurable interest compounded the effect of price moves of the underlying securities.  A failure of these underlying securities would become amplified because of the leverage and increased risk.  Instead of diversifying risk, (the advertised benefit of these securities because risk was supposedly spread out among many more investors) the leverage simply passed along the damage, almost one on one, to everyone involved.  Risk wasn’t diminished at all.  Instead it was spread out far beyond the original market.

Which doesn’t mean that there’s no legitimate investment uses of derivatives.  Far from it.

Stock options are derivatives.  If you own a stock and have insurable interest, you can use puts and calls to mitigate the effects of price moves.  In effect you can use these derivatives as a form of insuring your ownership interest as a stockholder.  You can speculate, of course, and don’t have to own a stock in order to buy a ”put” or a “call” on the stock.  If you own a put you can sell the put for a profit if the stock declines in price.  If you own a call you can sell the call for a profit if the stock goes up in value.

Commodity markets have long used derivatives in order to reduce risk.  You can buy “future” contracts in order to insure a certain “sell” price for your corn, or gold, or copper — you name it — at some date in the future.  This involves your insurable interest.  On the other side of the trade, if you are a user of a commodity, you can take the other side of the same future contract to insure a certain “buy” price.  Again you have an insurable interest.

But today huge investment bank trading desks dominate these commodity markets.  In most commodity markets today, the majority of future buyers and sellers are these trading desks which don’t represent anyone with an insurable interest.   And as with all the other markets where insurable interest has been broken, speculation has flourished and price volatility has increased dramatically.

The same process has similarly infected the currency and interest rate markets.  Legitimate trading by companies with insurable interest (exposure) to currency or interest rate fluctations is being overwhelmed by speculation, particularly speculation by the large bank holding company trading desks.  Instead of providing the traditional broker role in effecting the legitimate trades by those with insurable interests, these banks are dominating trade volume by speculating on their own behalf.  As with all markets where this occurs, price volatility increases, and volatility increases the cost of legitimate risk mitigation to productive enterprises.

Making all this worse is the growing concern that the current math models for assessing risk are wrong.  The basic underpinning of these markets, as a means to hedge risk, becomes less than worthless if the models are all wrong.  

But that’s a story for another day.  The lesson this post attempts to teach is that financial regulation should, as a principal, re-apply the concept of insurable interest.  The concept, by definition, imposes restraints on leverage and speculation.  And that, by definition, increases stability and reduces volatility and thus the expense of doing productive business all over the world.  

Markets are about predicting the future.  There’s an old saw that the equity markets have predicted 10 of the last 5 recessions.

That said, today’s markets are particularly dangerous because they’ve been overwhelmed by speculators, politely called “traders.”  The short term betting on number (price) movements, up or down, has even become a common avocation for retail speculators who have other jobs in their real lives.  Television advertisements about “trading” strategies are played at almost every commercial break on CNBC, the primary cable channel covering the markets.

So an inherently difficult job of predicting has been amplified because speculators aren’t interested in why a price does what it does, they only want it to do something and they want to guess which way it will go.  This type of market produces wider swings in prices on a daily basis.  That’s called volatility.  There’s even a volatility measurement that’s traded.  In today’s market you can even make a bet on whether markets will be more or less volatile.

For non speculators–productive endeavors like manufacturing, agriculture or mineral extraction–volatility is expensive.  These businesses need to hedge future prices on their raw materials (input) as well as their final product (output).  They also need to hedge their currency exposures, particularly if they sell, or import from, foreign countries.

Why is high volatility more expensive?  Simple.  If the price you’re trying to hedge is moving in a 2% range the hedge is less expensive than if the price is moving in a 10% range.  The greater the price moves, the more expensive the hedge because it must cover a larger risk.

Speculators profit from greater volatility.  From their perspective, volatile markets present more opportunities to profit from the numbers’ greater moves.   

Therefore, speculators profit from the increased expense volatility layers on the cost of doing business in the productive economy.  Speculators need that increase in cost (increase in volatility) in order to make their profits.   Massive speculation in today’s markets is hugely counterproductive and expensive for the real world economy.

The current recession is a direct product of this rise in speculative activity.  A whole new layer of securities for speculation have been layered on the base securities that existed before.  These new securities all fall into the “innovation” called derivatives.

The myth propounded by those who make huge profits (they turned out to be fake profits as it turned out) in derivative speculation is that this speculation provides “liquidity” to the markets.

Two observations about this myth.  The markets prior to the explosion in new derivatives didn’t suffer from a lack of liquidity.  It’s a problem that didn’t need solving.  But it did turn out to be a problem once the new derivatives gained dominance in global markets.  Funny about that.

Second, speculators need to amplify price moves in order to make greater profits.  As it turns out, the derivatives that were so “innovative” amplified a housing bubble in American into a global financial near collapse.   

Professional speculators profit primarily from the sell side in a recession.  For a moment, think about how selling an asset makes money.  Speculators sell “short” a security by borrowing it from the real owner.  Naked short selling removes even the need to borrow.  So very little money is invested to begin with by the speculator.  It’s a form of leverage.

The short becomes more and more profitable as the asset price slides downward.  At some point the speculator buys back the security he never owned and profits from the difference in price from where he borrowed the security and where he bought (known as “covered”) it back.  So, the speculator can sell a security he never really bought, say for $20, and then he can buy it back for $10 and double his money.

Please note that in this transaction, the market has lost $10 in liquidity until the speculator puts his profits back to work.  In fact, what would the price of securities be if all the shorts made money?  That would be zero.  A complete absence of liquidity.

Further compounding this sorry state of affairs is that large commercial banks were allowed to enter this business in a big way.  This used to be prohibited because regulators realized that the economic role of commercial banks is to lend money to business.  Regulators understood that speculative behaviour might damage a bank’s ability to provide this very necessary service to the productive economy.

Unfortunately for taxpayers, businesses and even national economies, these bank speculators are in the position of profiting from successful speculation, but because of their role in the greater economy, when that speculation goes sour, the banks can hold everyone else hostage and demand everyone else pay off the losses.  ”Heads, I win.  Tails, you cover my losses.”  In short, the taxpayer and the productive economy were the two “suckers” at the poker table.

And in a final insult to the non speculative people in the world who must pay the bills, all the liqudity in the world doesn’t really help much when the recession is caused by excessive bank speculation fueled by leverage.  That’s because the banks are insolvent from their speculations, and any money (subsidy) given them is not used to lend to productive endeavors, but used instead to rebuild insolvent balance sheets.  The banks have to pay off their speculative losses first.

There’s much much more to all this.  Someday I may write about how the big money in speculation comes primarily from the “squeeze,” a nuance of betting where large short or long positions are “squeezed” and forced to cover or sell at a loss. 

The relevant take aways from all this speculative behaviour?  Governments must enforce tough regulations on markets and prohibit the newer derivative securities entirely, or at minimum, place legitimate uses for them to trade on open, totally transparent markets.  And they must once again prohibit commercial banks from speculative activities.  Until that happens, legitimate investors must keep a larger portion of their portfolios in cash and await the day when the speculators are once again put under leash and saddle.

Beezer Addendum:  If I were king I’d prohibit short selling entirely.  There are options markets available where one can “bet”  on price movements.  Options don’t involve the physical selling or buying of a security and thus exert less direct pressure on the underlying security, up or down.   In addition options do provide a benefit to real investors in that they can be used to legitimately “hedge” risks.

An ETF (exchange traded fund) is a derivative of the real thing.  Although some Gold ETFs do actually own lots of the product, there are some doubts about whether they hold enough to satisfy a selling frenzy if for some reason one arrives.  Others are index funds that “track” the price of gold and don’t possess much of the real product.  And there are the leveraged gold ETFs, both long and short.

Gold’s red hot right now for lots of reasons, the major one apparently being investor concerns over sovereign debt and shaky currencies.   The theory is that if currencies start to suffer from inflation as debt is “monetized” then gold is the best safe haven.

That’s the story anyway.  But the more likely scenario is that the derivatives, available to retail investors who cannot or can’t be bothered with buying gold directly, will create demand that cannot be matched by the actual supply of gold. 

This will end badly.  Not for currencies and sovereign debt, but for investors who think they are getting gold safe with their gold ETFs.  Professional speculators will feed the frenzy on the way up, but they will be long gone (and probably short as well) to profit on the price plunge.

Yet another derivative induced spike in price, to be followed by tremendous losses (yet again) by fooled investors who thought they were actually making some type of investment.  Nope.  They are the suckers at the poker table.

Simon Johnson and James Kwak, co-authors of the blog The Baseline Scenario, have published a new book entitled “13 Bankers: the Wall Street Takeover and the Next Financial Meltdown.”   It is, far and away, the best explanation of how America developed an Oligopoly in banking, and why this Oligopoly created the 2008 near total collapse in finance.

Johnson in particular has the real world experience in banking.  He was the International Monetary Fund’s chief economist and in that job witnessed first hand the problems countries can encounter when their banks become politically powerful, wedding themselves to the political establishment in order to cement their control of a nation’s finance.  Currently he is Ronald A. Kurtz Professor of Entrepreneurship at MIT’s Sloan School of Management and a senior fellow of the Peterson Institute for International Economics.

Kwak is no slouch either.  He has an undergraduate degree from Harvard, a Ph.D. from the University of California, Berkeley  (in French intellectual history, no less) and is in the process of gaining his law degree from Yale.  Along the way he became a successful software entrepreneur.

The book is much more than a blow by blow description of the collapse.  It provides an historical recounting of what has been a conflict in America since her inception.  Johnson and Kwak, from the book’s cover: “…give a wide-ranging, meticulous, and bracing account of recent US financial history within the context of previous showdowns between American democracy and Big Finance: from Thomas Jefferson to Andrew Jackson, from Theodore Roosevelt to Franklin Delano Roosevelt.  They convincingly show why our future is imperiled by the ideology of finance (finance is good, unregulated finance is better, unfettered finance run amok is best) and by Wall Street’s political control of government policy pertaining to it.”

Through one crisis after another in America’s financial history,  US President’s have struggled against the threat(s) a financial industry can bring against democracy.  During the 20th century it was the Democrat party that traditionally took the lead in trying to effectively regulate banking and high finance.

Finance has always had the money it needed to try and buy votes–yesterday and today.  Daniel Webster once wrote to the powerful banker Nicholas Biddle, “I believe my retainer has not been renewed or refreshed as usual.  If it be wished that my relation to the Bank should be continued, it may be well to send me the usual retainers.” 

Imagine something like that being uncovered in an email between a US Senator and, as an example, Lloyd Blankfein at Goldman Sachs.  That both Blankfein and the Senator would have to immediately resign, and possibly serve some jail time, shows that the conflict between democracy and finance power brokers remains to this day. 

Nevertheless, finance still has the most money of any industry.  Finance is, far and away, the largest contributor to political campaigns.  It, again by a wide margin, supports the largest cadre of lobbyists in Washington DC.   High finance executives regularly serve at the highest level of the political power establishment–Democrat as well as Republican.  And this well known “revolving door” works the other way as well.  Like-thinking bureaucrats regularly walk out of their jobs into much higher paying positions in the financial industry.

But something has changed recently, particularly since the Presidency of Ronald Reagan in the 1980s.  The chronic push and pull battle between finance and democracy took a new twist.  For the first time, finance was gifted a political pass that was not tethered to its already powerful ability to spread the money around. 

From the book:  “Although Jimmy Carter had overseen the beginnings of deregulation with airlines, railroads, and trucking, it was more a topic for policy wonks than for the broader electorate; drawing in part on the ideas of economist Milton Friedman, Reagan made deregulation an ideological crusade.  Like so many successful leaders, Reagan managed to bring together many conflicting movements and beliefs in his coalition.  But his central message, as he said in his first inaugural address, was that ‘government is not the solution to our problems; government is the problem.’”

Brilliant.  Armed with an intellectual economic philosophy espoused by Friedman and the so-called “Chicago School” of economics, Reagan began the dismantling of restrictions put in place under FDR during the Great Depression.  Democrats still resisted, and Reagan didn’t win all his proposals to deregulate finance, but the great unraveling had begun in earnest.  For the first time, bankers had the upperhand not only in money but in ideology.  The process of “intellectual capture,” of Washington by Wall Street was underway.

The final nail in the building of a regulatory capture coffin for democracy came when Wall Street discovered it could use it’s new found freedom to boost something near and dear to Democrat hearts:  Home ownership.  Using the securitization of mortgages, and the resulting explosion of derivative use, deregulated banks and non banks flooded the mortgage market with money.  Rates were low, then lower and long held fiduciary standards for home ownership were discarded almost completely.

Fifty years of banking stability, of the almost complete absence of financial turmoil in America, was about to come to an end.  The final bulwark against financial oligarchy in America, the Democrat party, was compromised.  Neutered.

Read the book.  It’s easy to follow, even when the derivatives are explained.  And it is thorough, recording the history as well as the underlying intellectual battle over deregulation. 

Next.  What to do?

Charles Munger is Warren Buffett’s closest sidekick and a billionaire owner of Berkshire Hathaway stock.  He is a brilliant investor in his own right, and Munger talks on investment are as sought after within the professional investment community as are Buffett’s.

Today on CNBC Maria Bartoromo asked Munger what he thought of derivatives.  She was talking about the type of derivatives that played a leading role in transforming the real estate slump into a global earthshaker.  And most recently got Goldman Sachs charged with fraud by the Securities Exchange Commission (SEC).

Munger was to the point.  “I’d get rid of them.”  He isn’t talking about the traditional methods of hedging risk exposure that preceeded the “innovation” of these toxic derivatives.  Munger isn’t against legitimate hedging of real assets.  He just is against the modern, steroidal, derivatives that were sold as hedging instruments and then totally exploded in a totally illiquid market. 

So count Munger, a Republican and among those who should know, as one experienced professional who realizes that these derivatives, as President Clinton also observed when asked about them, “have no underlying purpose.”

Except to skim off billions in commissions and spread profits by Investment Banks.

Get rid of them.  And if that can’t be accomplished, make them all boilerplate and traded on public exchanges where the traders cannot make outsized profits.  If we do that then IBs will have to return to doing what they’re supposed to do: Raise funds for productive investment opportunities.