Gambling on Our Financial Future: How the Federal Government Fiddles While State Common Law Is a Safer Bet to Prevent Another Financial Collapse

Abstract

Many politicians and commentators agree that credit default swaps (CDS) played a significant role in the worldwide financial crisis of 2008. Yet, few who observe this role are aware that CDS were set loose on the economy by the pre-emption of thousands of years of public policy. Since the time of Aristotle law, philosophy, and public policy have been united in their opposition to gambling, and in particular, financial gambling. Viewed as a socially unproductive zero sum wealth transfer, the law has generally refused to permit parties to use the courts to enforce wagers. For centuries, courts and legislatures worked in harmony to control, and in some cases punish, financial wagers particularly on the heels of financial panics precipitated by speculative wagering. When the financial industry developed complex derivatives that permitted banks and other institutions to bet on the financial health of companies and portfolios of mortgages and other financial assets, legal experts recognized these contracts would be unenforceable as against public policy under state law. The industry turned to the federal pre-emption power which was wielded not only to exempt CDSs from all state law but to exempt CDSs from all federal regulation. This strategy within the United States was repeated in other countries such as the United Kingdom. Ironically, claiming to reduce systemic risk, governments issued a “Get out of Law Free” card to these financial gamblers. The result was an exponential increase in the size and frequent spinning of this newly engineered roulette wheel. When the wheel stopped it was not the gamblers but the U.S. economy which lost the bet. After describing the nature of CDS contracts and the market for them, this article traces the ancient philosophical (beginning with Aristotle’s Nicomachean Ethics) and legal antipathy to gambling, examing the nuanced distinctions made between gambling and socially useful transactions such as insurance. Next the article traces the rejection of that wisdom by federal preemption and concludes that CDSs and other financial wagers should again be subjected to state law and public policy against financial wagers. CDS contracts that serve an economic purpose other than gambling, such as insurance or risk hedging, should be legally enforced (subject to appropriate regulation) but pure financial gambling should be constrained by the highly developed and ancient state common and statutory law still on the books of the various states. We cannot afford to continue to gamble with the world’s financial future by allowing legally enforceable financial wagers to drive the economy. The U.S. federal government needs to stop fiddling with regulatory turf wars between the SEC and CFTC and place a safer bet on state courts and legislatures enforcing ancient public policy.