Surely no one really believes the US taxpayer should pay off the winnings of rank speculators, including the traders in credit default swaps. I offer a modest proposal for fixing the problem: a tax on each gambling transaction of 80%.

The Treasury gets the money, and uses it to repay the bailout, and to finance the losses that are yet to come as the credit scandal ripples through banks and on into pension funds, hedge funds and the rest of the hollowed-out shell that used to be a mighty financial engine.

How do we know if a transaction is for gambling? We’ll define the term “Naked Credit Default Swap”, or Naked CDS. This will be credit default swap in which the protection buyer either (a) doesn’t own the reference entity debt in an amount equal to the total amount of credit protection it purchased, at the date or dates on which the CDS is purchased, or (b) doesn’t hold that debt as long as the transaction remains open. As an example, Hedge Fund buys a credit default swap from AIG. Hedge Fund agrees to pay a stream of payments to AIG, say $50K per quarter for five years, and AIG promises to pay off if Lehman Bros. defaults on reference credit, say $10 mn of Lehman Bros. debt. Hedge Fund doesn’t own any Lehman Bros. debt. It just wants to bet that Lehman Bros. will default before the term of the CDS ends. This is a Naked CDS. These are the transactions that get taxed.

If Hedge Funds owns Lehman Bros. bonds on the date of purchase of the CDS, and holds them as long as the transaction remains open, it pays only regular income tax on the profits, if any.

The only exception to the Gamblers Tax is for netted transactions. If Hedge Fund buys a CDS and later sells a CDS on the same reference entity (the term reference entity means the company that issues the financial instrument covered by the CDS), only the net profit is taxed. But you can’t set off profits on a CDS on one reference entity with losses from a CDS on a different reference entity. You can find a couple of detailed examples at the end of this post.

The gamblers who bet against Lehman Bros. had a real reason to want Lehman Bros. to fail. Their bet is going to pay off for them, and some of the money came from AIG, and guess who put up the AIG payments? That’s right, you and me, when we bailed out AIG. The Gamblers Tax sees to it that we get our money back.

Of course, there are all kinds of explanations from all kinds of interested parties for why this CDS market is a great thing: lubricates the market, provides market information to buyers and sellers, government shouldn’t interfere in the mighty free market blah blah blah. These explanations were crafted by the high priests of finance and their mouthpieces. Ignore them. They are abject failures. Why should they even have a voice in figuring out the repair job? Didn’t we just vote to quit listening to the screw-ups? It isn’t like there weren’t people, famous people, who figured out that this stuff was a scam. Warren Buffet said he didn’t understand them and wouldn’t buy them. Look what this guy says (H/T Alison).

Perhaps in other times, this kind of gambling wouldn’t be such an issue. It doesn’t fit that high-minded theory that the function of the financial markets is to allocate capital to its highest and best use, which is supposed to benefit society, but there has always been some speculation. The CDS market isn’t about allocating capital. It’s set off a gambling spree that put the financial foundation of our society in danger of complete collapse. Now every player in this market must take a giant haircut and share in the disastrous losses.

This plan has other advantages. It doesn’t affect people who actually owned securities when they bought a CDS, and who might actually be hedging their long positions. It is easy to enforce, and easy to understand. No one can complain about the tax, because the tax status of CDSs is unclear at present.

But mostly it’s fair because taxpayers recoup some of the money they have had to pay as part of this travesty of a bailout, from the gamblers who wrecked the system in a paroxysm of incompetence compounded with greed.

Examples. Suppose AIG sold $10,000,000 of protection on Lehman Bros. bonds to Hedge Fund, and that Hedge Fund doesn’t own those bonds. AIG gets a stream of payments from Hedge Fund, say $275,000 per quarter for two years. Then Lehman Bros. collapses. The reference entity debt is worth $.08 on the dollar, so AIG owes Hedge Fund 92% of $10,000,000. That comes to $9,200,000. The profit equals the payoff less the payments to AIG of $2,200,000, or $7,000,000. Hedge Fund pays a Gamblers Tax of 80% which is $5,600,000. It gets to keep $1,400,000, which works out to about 32% per annum on its “investment” of $2,200,000.

If it lost money because it sold protection on the same reference bond, that loss can be set off against other income, but not income from the winning Naked CDSs.

If the winning bet was paired with an offsetting sale of protection on the same reference credit, the results can be netted. Suppose that Hedge Fund was satisfied with its gains when the price of Lehman debt was $.40 on the dollar, and sold protection to fix its winnings at $.60 on the dollar. The premium for this transaction is, say, $150,000 per quarter. If Hedge Fund collected for a year before Lehman Bros. collapsed, it got $600,000 from its protection buyer. The results are netted out. Hedge Fund gets $9,200,000 from AIG, and pays $3,200,000 to its protection buyer. The profit is $9,200,000 less the 2,200,000 in payments it made to AIG, plus the $600,000 payments it got from its buyer of protection, and less the $3,200,000 it pays to its protection buyer. The net of these is $4,400,000. Then it pays 80% of that amount as a tax. The protected party would also pay a Gambler’s Tax unless it held Lehman Bros. debt in the amount of the transaction.

If it bought two Naked CDSs, it would do this calculation for each, separately, and pay a tax equal to the sum of the taxes due on each. If one produced a profit, and the other a loss, it would pay taxes on the winner, and it could use the losses to offset ordinary income from other business operations, but that would not reduce the taxes owed on the winning transaction.

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