Of the few pleasures in law school, I enjoy learning about the America of old. And comparing it with the country we are today.

 

For example, reading one case recently, I realized that at the turn of the 20th century, the Mississippi legislature made it a misdemeanor crime to trade cotton futures. Ole' Miss determined it was against the public interest to engage in Wall Street-style gambling on Mississippi's main economic engine.

 

Go figure. A legislature stood up to the monied interests of its day. If only we could have found a legislature to outlaw trading of credit default swaps, and other exotic securities that are now toxic, we could have prevented the housing bubble, and maybe saved ourselves from this recession.

 

It's not like human history has not seen the negative impact of bubbles and futures trading before. But it was a surprise to me when I apprehended this gem about futures' regulation in my Conflicts of Laws class.

 

Conflicts, of course, is the study of what happens when the right thing changes from state to state, and how courts determine which law to apply when a contract made in Connecticut by people from Delaware and Michigan, to be paid in California is breached in Ohio, when it should have been performed in Illinois.

 

Each state has its own interests, and courts have to weigh these against Constitutional considerations, and most consider the area of conflicts to be hopelessly confused. It’s pretty much a coin flip, even where seemingly simple things like land transactions don’t always go by the rules of the state where the land is.

 

Generally, I find conflicts to be the study of how corporations manage to evade lawful restrictions on their aggregations of capital and pursuit of profit. Fauntleroy v. Lum, 210 U.S. 230 (1908), the case focused on illegal cotton futures trading, is run of the mill, and the bad guy wins.

 

Written by Mr. Justice Oliver Wendell Holmes, that giant of American jurisprudence, Fauntleroy v. Lum holds that despite the illegal status of cotton futures trading in Mississippi, a man can win money on illegal cotton futures in Mississippi, go to Missouri to win a judgment against the debtor, then return to Mississippi and have a court enforce that judgment.

 

Holmes reasoned that the full faith and credit clause of the United States Constitution demanded Mississippi to enforce the judgment even though trading on cotton futures is illegal in Mississippi and against its interests.

 

The guy who did it in Mississippi and won, and went to a court in Missouri to enforce his winnings against a Mississippi resident can do so, with impunity.

 

Mississippi's interest in preventing activities that could destroy its economy is subservient to Missouri's interest in having a stable judgment that will be honored in all 50 states, at least according to Holmes and the Supreme Court of 1908. I reckon that the Roberts Supreme Court would do the same today.

 

It is an unpalatable decision at best, and one that subverts the power of sovereign states. It should be expected from a Constitution written to place the rights of property and slaveholding on the same plane as civil rights, if not a higher plane than civil rights.

 

I savor, though, the fact that at one pointing an America somewhere, credit default swaps and securitization of mortgages would have been illegal. Although according to a 2007 textbook by Robert Kolb and James Overdahl, Futures, Options and Swaps, the federal government didn’t begin regulating futures until 1922.

 

Roosevelt's New Deal in 1936 created the Commodities Exchange Act, which Clinton amended in 2000. Futures trading, though, is an ancient sport, first reviled by Aristotle with the story of Thales, a poor philosopher from Miletus. This little fable from Wikipedia:

Thales invented a "financial device, which involves a principle of universal application." Thales attempted to predict the quality of the olive harvest in the fall. Based on his estimate of a good harvest, he contracted with local olive-press owners to buy exclusive use of their olive presses when the harvest was ready.

Thales bought low because no one else pretended to guess on the quality of the harvest. The olive-press owners, being human, wanted money now rather than later, so they hedged against the possibility of a poor yield. The quality of the crop was irrelevant, because at harvest, presses are always needed.

Thales owned the rights on all of them, and he rented them at rates he set, which made him rich.

“Futures market regulations are designed to deter manipulation, abusive trading practices, and fraud, because these activities interfere with the process of price discovery or the efficient transfer of unwanted risk,” Kohl and Overdahl write.

 

Funny thing, that federal government. Congress in 1974 created the Commodity Futures Trading Commission in 1974, but little good it has done us. The reason: "Industry members themselves must perform a regulatory role." Self-regulated industries never work. Look at the legal profession.

 

The only commodity in which it is currently illegal to trade futures is onions, according to Kolb and Overdahl. Trading in onions futures was outlawed in 1958 by Congress. "Due to concerns by onion growers of futures-related speculations and volatile prices," Congress prohibited dealings in onions futures, according to the textbook.

 

Where was this wisdom in dealing with everything else? Back in 2000, Clinton signed the Commodity Futures Modernization Act, sponsored by Phil Gramm, which allowed deregulated the commodities market, allowing Credit Default Swaps or CDSs.

 

Senator Chris Dodd was a lead proponent of this act, and was proud of his involvement. Yet this week, Dodd has come out with a bill to attempt to reign in financial giants, but not end commodity trading.

Journalist Matt Taibbi explained CDSs to Amy Goodman of Democracy Now!:

MATT TAIBBI: "It's really just gambling. But it's a situation where an outside company like AIG can offer to guarantee the investments of a bank like Goldman Sachs.

And say a bank like Goldman Sachs invests an enormous amount of money in a housing market, but they want protection in case their investments default, unless some of those mortgages and loans that they're investing in default, so they go to AIG, and they offer to pay them a premium every month, in exchange for which AIG will pay the entire amount of their mortgages in the case of default. So it's sort of like an insurance policy against the investments of these investment banks."

AMY GOODMAN: "So you have—Cassano sells $500 billion of CDS protection with at least $64 billion of that tied in the subprime mortgage market."

MATT TAIBBI: "They were designated outside the regulation of—they couldn't be regulated as futures commodities or as gaming, so there were no rules about this. So you could sell as much CDS protection as you wanted, but you didn’t have to actually post any capital when you did it. You know, when you sell a bond, somebody actually has to—you know, a $100 bond, somebody actually has to have $100. Well, that’s not the case with CDSs. You could sell as much of the stuff as you wanted, and you didn't have to have any money at all. And that's why AIG got in so much trouble."

 

And that is why we are in so much trouble. Congress has surrendered to the banks.

 

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