Derivatives And Usury: The Role Of Options In Transactions Used To Act In Fraud Of The Law

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Derivatives And Usury: The Role Of Options In Transactions Used To Act In Fraud Of The Law

Emilio Barone

Luiss – Guido Carli (Dpt. of Economics and Finance)

Gennaro Olivieri

LUISS Guido Carli University

May 17, 2015

Abstract:

The search for derivative contracts with complex features can also be explained as the market’s attempt to elude the restrictions imposed by the law on money loans. This is an undesirable effect of anti-usury rules. It can be added to the one mentioned by Montesquieu and Adam Smith, who pointed out that usury increases with the severity of the prohibition, since the lender indemnifies himself for the risk he runs of suffering the penalty.

In this paper we look at some of the ways in which derivative contracts can be used to circumvent anti-usury provisions and conceal money loans made at exorbitant rates.

After examining the simplest cases, we will consider more complex contracts, such as swaps with embedded options, which are often used in dealings between banks and municipalities. Our thesis is that, in all these cases, in order to detect usury, we have to calculate the contracts’ option-adjusted yields.

Derivatives And Usury: The Role Of Options In Transactions Used To Act In Fraud Of The Law – Introduction

Fear that the current crisis has caused a credit crunch, with a consequent increase in usury, makes the analysis of the ways in which usurious loans can be “masked” highly topical.

In this paper we look at some of the ways derivative contracts can be used to circumvent antiusury provisions and conceal money loans made at exorbitant rates.

After examining the simplest cases, we consider more complex contracts, such as swaps with embedded options, which are often used in dealings between banks and municipalities. Our thesis is that, in all these cases, in order to detect usury, we have to calculate the contracts’ option-adjusted yields.The search for derivative contracts with complex features can also be explained as the market’s attempt to elude the restrictions imposed by the law on money loans. This is an undesirable effect of anti-usury rules. It can be added to the one mentioned by Montesquieu and Adam Smith, who pointed out that usury increases with the severity of the prohibition, since the lender indemnifies himself for the risk he runs of suffering the penalty.

The borrower found himself under the necessity of paying for the interest of the money, and for the danger the creditor underwent of suffering the penalty of the law [Montesquieu, 1748, p. 398]. This regulation, instead of preventing, has been found from experience to increase the evil of usury; the debtor being obliged to pay, not only for the use of the money, but for the risk which his creditor runs by accepting a compensation for that use. He is obliged, if one may say so, to insure his creditor from the penalties of usury [Adam Smith, 1776, Chapter IV, p. 158].

2. In The Footprints Of Russell Sage

Derivatives were also used a long time ago to circumvent anti-usury law. This is the case, for instance, of Russell Sage (Figure 1), a U.S. financier (1816-1906) whose wealth at the end of 1800 amounted to $100 million, or more than $250 billion in today’s terms. Russell Sage was charged with violations of the usury laws of the State of New York. Actually, he was accused of being the leader of the “Usury Ring.” He was described as follows in the Encyclopedia Britannica (1963): SAGE, RUSSELL (1816-1906), U.S. financier, was born Aug. 4, 1816 in Oneida county, N. Y. He began his career in the grocery business. In 1853 he purchased the Troy an Schenectady railroad from the city of Troy, N. Y., and sold it to the New York Central railroad. He participated in the development and reorganization of railroads in the northwest. Sage moved to New York City in 1863, becoming a dealer in “puts” and “calls” and the “call money” market. He worked with Jay Gould, manipulating the stock of the Union Pacific and other companies, and was Whig representative in congress (1853- 57). Sage died July 22, 1906, leaving his estate to his wife, MARGARET OLIVIA SLOCUM SAGE (1828-1918). Mrs. Sage established the Russell Sage foundation in 1907. During her life she made public gifts of $40,000,000, and when she died Nov. 4, 1918, she left $36,000,000 to be distributed to various public institutions. (J. R. Lt.)

Nobody played a more important role than Sage in the development of US railroads (he eventually acquired an interest in more than 40 railroads, serving as director or president of 20). He amassed part of his fortune not only by investment-banking operations on railroads but also by trading on the stock exchange (for instance, he used the technique of short selling – learnt from Jacob Little – to exploit the panic selling of 1857).

Derivatives And Usury: The Role Of Options In Transactions Used To Act In Fraud Of The Law

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