It is common wisdom that the incoming administration cannot possibly increase government tax revenues in these horrific economic conditions. However, this common wisdom is simply wrong.
There is a major new source of revenue available to the government – the shadow financial system.
While these shadow financial markets allow individuals and companies to hedge a variety of risks, their main raison d’etre has become financial arbitrage and speculation. They should be seen (and taxed) for what they are – largely unlicensed gambling establishments.
The $860 trillion “Over the Counter” (OTC) financial derivatives market is one of the largest casinos of global finance. The games played within it are zero-sum – for every winner there is a loser. Presently, winnings are largely private, while losses have been socialized.
The intelligent taxation of some of the games in the “global casino” would lead to control of an unregulated market, probably redirect some formerly speculative capital to the real economy, and generate potentially enormous revenues for the government. Care would have to be taken so that the taxation of each type of financial game is high enough to maximize government revenues from the specific activity, yet low enough so that the activity continues.
A combination of relatively modest though transaction-specific stamp taxes on the underlying documentation, which would not be legally binding in the absence of the stamp, combined with well-calibrated excise taxes on winning positions would finance any number of bridges to whatever destinations. A modest 0.25 percent tax on the total volume outstanding would yield $2.15 trillion of new revenues.
While it can be argued that the transactions are already taxed, too many of the players, particularly of the most sophisticated financial games, operate from or book profits in off-shore tax havens. We can be sublimely confident that the best tax planners and arbitrageurs in the world are able to ensure that most of the “winnings” in the casino escape the tax net while most of the losses end up as deductions to taxable income.
In certain cases the level of taxation of gains should be close to confiscatory. Some of these markets are a menace to financial stability and need to be controlled if not closed down. The credit default swap (CDS) market is one such – and surely the largest floating craps game in the history of the world. As in craps, the players wager money against one another and await the outcome of a roll of the dice – though in this case the bets are “for and against” a company’s survival – technically its ability to continue to meet its financial obligations.
In the current environment, speculators are even able to load the dice against the companies they target. As they bet against a company, the market price of credit protection for that name rises, the target has fewer options to raise capital, its borrowing costs will tend to rise, and its bank and trade credit will be curtailed by cautious lenders and suppliers, further constricting liquidity and making default more likely – shifting the odds shift in favor of the speculators.
There are several trillions of dollars in the credit default swap market which are not connected to any underlying risk of loss due to ownership of a debt obligation. These are no more than wagers for and against the financial viability of specific companies or countries. As of December 12, 2008, for example, there was $166 billion dollars worth of bets on the republic of Turkey (Italy had $158 billion). The Turkish government only has $94 billion of foreign debt, and it is unlikely that every debt holder has hedged it with a credit default swap. The arithmetic is pretty simple – there is a lot of speculation going on.
The bettors, that is, the buyers and sellers of this insurance have to pay to play. Buyers of credit default swaps have to pay up-front premiums to sellers as well as ongoing sums over the life of the contract. On the other hand, sellers often have to post collateral to cover their bets and reassure the purchaser of their ability to make good on the wager. At other times, the underlying creditworthiness of the seller is adequate, and the only “price” the seller has to pay is the risk exposure to the name being insured.
Conditions can change: AIG, for example, seems to have written a very large amount of credit default protection (only a few hundred billion dollars) based on its AAA rating, only to be forced to post collateral on some of the contracts when its own credit rating was downgraded. It seems that AIG wrote large amounts of this protection in favor of European banks which bought it for regulatory reasons and stand to make windfall profits if the underlying obligors default.
Most taxpayers would be astonished to learn that some of the proceeds of the government’s $152 billion AIG bail-out were needed to cover bets. Taxpayers may be still less enchanted if their tax dollars end up being used to payoff those bets. They may never know; few details concerning the use of the proceeds of the AIG bailout or the recent asset purchases of the Federal Reserve have been confided to the sporting (taxpaying) public despite huge bets being made with taxpayer money.
Financial players seem to prefer locked in profits based on timing differences to speculative positions. They first buy credit protection on a specific obligor at a relatively low price. Later, as perceptions of that obligor’s creditworthiness deteriorate, credit protection becomes expense for buyers. At this point the financial player will square his position by selling credit protection on the obligor at the higher price. In this way, players lock in profits, whether the underlying obligor defaults or pays on time. They are not the major profits that come from a winning bet, but they are certain and relatively risk free.
Positions can also be taken in the opposite direction – credit protection can be sold at relatively high prices, say on Wachovia prior to the Wells Fargo purchase announcement, and then sold at lower prices on the news of the announcement. This financial craps game allows bets for any point of view. The netting of exposures appears very common; the Depository Trust and Clearing Corporation (DTCC) reports about $14.4 trillion of gross notional exposure to credit default swaps of the largest 1000 reference entities while the net exposure is reported as roughly $1.5 trillion. This is important because a stamp tax on documentation would generate revenues on the entire gross amount while a much higher rate of tax would apply on only the small portion of cases where defaults actually occur.
Those on either side of that net position will book gains or losses if credit events occur. The key point is that this gain or loss will be purely speculative, and the gain is conceptually equivalent to gambling revenue. The beauty of taxing away most of these winnings would be that the tax only hits capital employed in speculation (rather than supporting genuine economic activity) and hits players who are too often able to avoid paying taxes anyway.
Taxation would move the government into the role of the “house” in the credit default swaps market, instead of the patsy, as it has been to date.
From the tax point of view, someone genuinely hedging their credit risk would not recognize any gain – the proceeds of the credit default swap would offset the loss on the bond. Entities which had no off-setting losses would, on the other hand, face a stiff tax on their winnings. The government might even also decide to treat the deductibility of the losses like gambling losses – limiting the deductibility of losses to the amount of taxable offsetting gains. This step would probably be too drastic but would merit study.
There would be several advantages to taxing the financial derivatives market in general and the credit default swaps market in particular:
- The U.S. government would have a new source of revenue which would not come from the “real” economy. This is capital that is tied up in speculative instruments, so taxing it would be unlikely to affect the “real” economy, except positively.
- The people who bought (or buy) credit default swaps to insure their actual risks would not be taxed, as they would exchange one asset for another at the same value. This would preserve the product for a legitimate purpose. This would also take some pressure off obligors because the number of players who would be willing to bet against a company (buy credit insurance against default) for only a small gain would be reduced, allowing the companies’ creditworthiness to be determined by more normal market forces, such as suppliers and banks rather than financial speculators. Corporate bond yields might narrow as people try to purchase the outstanding paper for less than the cost of the tax if they really believe a default is in the offing.
- If a seller of credit default insurance was “too big to fail” or, as in the case of Bear Stearns, too interconnected to fail because of its credit default swap obligations, the government would obtain a vast amount of the resources for the rescue from the tax on the winners – rescues based on such payments would be a lot cheaper for the taxpayer.
- If the losing institution was not “too big to fail,” the taxes would be simply net revenue for the government to use for stimulus or to reduce its own deficit.
- It would essentially cut back the unknown taxpayer exposure to the rest of AIG’s credit default swap book as well as those in the as yet un-rescued companies and some of the banks.
There are many other benefits but these are the main ones. This form of taxation ought to be politically popular, though financial market participants will no doubt dismiss the idea as unworkable. There have been some calls for the speculative CDS contracts to be “torn up” – legally voided by government fiat. That would be a good second best solution to the harmful side-effects of this market, but would pass up a marvelous opportunity to tax financial speculation for the good of the wider society. Why close the craps game when you can keep profiting from it?
Mark Foley has worked for the business intelligence and integrity risk management firms Thatcher Associates and Forensic Investigative Associates in New York. He has also worked in the financial services and credit risk management sector with Bank of Boston and its emerging markets spin-off in Turkey, Oyak Bank. Mark is currently completing his PhD dissertation on contagion in global financial markets at Rutgers University, Division of Global Affairs.