When Bankers Become Bettors

Addiction counselors tell their clients, "We can't help you until you admit you have a problem." It's time for American financial institutions to admit they have a gambling problem.

JPMorgan Chase & Co. last week announced losses, perhaps greater than $5 billion, from bad derivatives bets. Last year we saw UBS suddenly lose $2.3 billion and the hedge fund MF Global implode from derivatives trading. And let's not forget the 2008 failures of American International Group Inc. and Lehman Bros., which triggered an economic crisis we're still recovering from. All from speculative trading by financial institutions in derivatives – put bluntly, from gambling.

Wall Street firms often misleadingly describe derivatives as "assets," "investments" or "insurance." (This last label is sometimes correct but not nearly as often as it's claimed.) To really understand derivatives, it's essential to recognize that a derivative is simply a wager.

This is not a metaphor or figure of speech. Derivatives are literally wagers, agreements that one person will pay money to another if some specified event occurs – if interest rates rise, a currency falls, I'll Have Another wins the Belmont Stakes. A Wall Street trader would call a racetrack betting ticket an "I'll Have Another victory swap."

As the insurance industry shows, wagers can be used to offset risk. When you buy fire insurance, you are betting the insurance company that your house will burn down. If it burns, you win the wager, offsetting the loss of your home.

But wagers are also used to speculate, by trying to profit from predicting the future better than others can. If I bet the Yankees will make the World Series, I'm seeking profit, not trying to reduce risk.

Jamie Dimon, JPMorgan's leader, may claim his bank lost on derivative swaps entered into to temper the risk of other derivatives, which in turn reduced risk on bonds the bank holds. But this sounds more like hedging a speculative bet than real insurance. After all, the best and easiest way to hedge against a decline in the value of a liquid asset like a bond is simply to sell it. Or look at it this way: How can merely buying insurance cause you to suddenly lose $5 billion?

Betting – including betting with derivatives – is a zero-sum game. Winners' gains always come from losers' pockets. Worse, unless a bet is truly insurance, both sides take on risks they weren't exposed to before.

So when banks turn away from the boring business of making loans and helping real companies raise money by issuing stocks and other securities, to focus instead on risky trading primarily to make profits, we should expect to see exactly what we have seen. There are more big winners – hedge fund manager John Paulson made billions betting on the subprime mortgage crisis – but more big losers, more dramatic institutional collapses and much more systemic risk.

The 2008 credit crisis has proved, painfully, how systemic risk harms our economy. And banks' gambling in the zero-sum attempt to earn more dividends for bank shareholders and bigger bonuses for bank executives doesn't provide investment capital directly to real businesses, the way lending and "underwriting" (helping companies raise cash by selling stocks and bonds) do.

While derivatives traders often repeat (without solid evidence) the self-serving claim that their trading is essential for liquid markets and accurate prices, no one who lived through the derivatives-triggered liquidity crunch and wild price swings of fall 2008 should attach much value to these unsupported assertions.

History tells us what we can do to keep our financial institutions from collapsing in derivatives-fueled disasters. After the Depression, Congress passed the Glass-Steagall Act, which prohibited deposit-taking banks from indulging in risky proprietary trading. But thanks to intense lobbying, especially by Citibank, Congress eliminated that prohibition with the Gramm-Leach-Bliley Act of 1999. A year later, as part of the same deregulatory frenzy, Congress overturned state and federal laws that restricted speculative derivatives trading to "clearinghouses" run by regulated exchanges.

That wave of financial deregulation explained both the sudden rise of an enormous derivatives market and the trading disasters and institutional collapses that followed.

The Dodd-Frank Act attempts to stuff the systemic-risk genie back in the bottle by once more restricting deposit-taking banks from making risky bets with their own accounts (the so-called Volcker rule) and moving speculative derivatives trading back into regulated clearinghouses. Unfortunately, the financial industry has responded by sending out an army of lobbyists and lawyers to try to dilute the rules and create loopholes big enough, in the words of Michigan's Democrat Sen. Carl Levin, "that a Mack truck could drive right through it."

Our banks still won't admit they have a problem. That means we still have a problem too.

Stout is a professor of business law at Cornell University and author of "The Shareholder Value Myth: How Putting Shareholders First Harms Investors, Corporations, and the Public." This commentary first appeared in the Los Angeles Times.