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Making Fraud Legal

Robert FitzPatrick, in a story at Sunday Times, published in Sri Lanka, has an interesting story about the relationship between our current financial crisis and how lobbyist's bring about laws which enable fraud.

The big bad word that is normally reserved for illegal pyramid schemes - COLLAPSE - is now referenced daily in discussions about our stock and credit markets. How could legitimate and regulated markets that are watched over by the Securities & Exchange Commission (SEC) "collapse"?

Isn't the whole idea of federal regulation to prevent such a disaster? Isn't the SEC supposed to stop irresponsible or fraudulent activities that cause collapse?

If these markets really were on the brink of collapse before the federal bailout, does it mean that there are fundamental similarities between our securities markets on Wall Street that sell credit, stocks, bonds and insurance and the pyramid schemes running rampant in neighborhoods and churches that sell fruit juice, soap, and the "opportunity of a lifetime"?

There are more similarities than most people realize. Pyramid selling schemes are Main Street's own version of "Wall Street Greed." One major similarity is the effort of promoters in both fields to get fraudulent business practices legalized.

Both pour millions of dollars into lobbying politicians in state legislatures.

Both maintain Washington DC offices working everyday to change federal laws so they can do what many states and current federal laws and policies declare are illegal.

And both - multi-level marketing, and Wall Street - have been successful in legalizing fraud or at least in preventing anti-fraud laws, written to protect the public, from being enforced.

With respect to Wall Street, Robert is referring to the Commodities Futures Modernization Act 2000, a topic the CBS's 60 minutes covered in October.

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"If I thought certain mortgage securities were gonna fail, I could go out and buy insurance on them without actually owning them?" Kroft asks Eric Dinallo, the insurance superintendent for the state of New York.

"Yeah," Dinallo says.

"The irony is, though, you're not really buying insurance at that point. You're just placing the bet."

Dinallo says credit default swaps were totally unregulated and that the big banks and investment houses that sold them didn't have to set aside any money to cover their potential losses and pay off their bets.

"As the market began to seize up and as the market for the underlying obligations began to perform poorly, everybody wanted to get paid, had a right to get paid on those credit default swaps. And there was no 'there' there.

There was no money behind the commitments. And people came up short. And so that's to a large extent what happened to Bear Sterns, Lehman Brothers, and the holding company of AIG," he explains.

In other words, three of the nation's largest financial institutions had made more bad bets than they could afford to pay off. Bear Stearns was sold to J.P. Morgan for pennies on the dollar, Lehman Brothers was allowed to go belly up, and AIG, considered too big to let fail, is on life support to thanks to a $123 billion investment by U.S. taxpayers.

"It's legalized gambling. It was illegal gambling. And we made it legal gambling...with absolutely no regulatory controls. Zero, as far as I can tell," Dinallo says.

"I mean it sounds a little like a bookie operation," Kroft comments.

"Yes, and it used to be illegal. It was very illegal 100 years ago," Dinallo says.

In the early part of the 20th century, the streets of New York and other large cities were lined with gaming establishments called "bucket shops," where people could place wagers on whether the price of stocks would go up or down without actually buying them.

This unfettered speculation contributed to the panic and stock market crash of 1907, and state laws all over the country were enacted to ban them.

"Big headlines, huge type. This is the front page of the New York Times," Dinallo explains, holding up a headline that reads "No bucket shops for new law to hit."

"So they'd already closed up 'cause the law was coming. Here's a picture of one of them. And they were like parlors. See," Dinallo says. "Betting parlors. It was a felony.

Well, it was a felony when a law came into effect because it had brought down the market in 1907. And they said, 'We're not gonna let this happen again.' And then 100 years later in 2000, we rolled them all back."

The vehicle for doing this was an obscure but critical piece of federal legislation called the Commodity Futures Modernization Act of 2000. And the bill was a big favorite of the financial industry it would eventually help destroy.

It not only removed derivatives and credit default swaps from the purview of federal oversight, on page 262 of the legislation, Congress pre-empted the states from enforcing existing gambling and bucket shop laws against Wall Street.

"It makes it sound like they knew it was illegal," Kroft remarks.

"I would agree," Dinallo says. "They did know it was illegal. Or at least prosecutable."

The bucket shops set up in the 1900's were not just undercapitalized, they cheated the consumer. The bucket shops allowed front running and were a general menace to investment.

But on the other hand, the bucket shops opened up Wall Street to the general investing public - their attraction was the low number of shares they traded making trades more affordable for the middle class.

I haven't seen any papers on the CFM Act and a discussion of gambling, so if any readers could point me to one, I would appreciate it.

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Full post as published by Misleading Advertising Law on November 10, 2008 (boomark / email).