The bank across the street just put in a new front window.

They want to make sure that if the window gets broken, they will not have to pay the cost of replacing it, so they buy insurance.

They buy that insurance from a company that sells hazard insurance. That company has done studies to determine how often a window like the one the bank has will get broken and based upon that, they quote a premium which the bank pays.

The insurance company maintains liquid reserves which are set by law so the bank can be assured that the insurance company will have the money to pay to replace the window if it gets broken.

What if I were just sitting across the street when the window was installed and wanted to bet with you that the window will get broken within the next two years.

You say it's unlikely, so you tell me that if I pay you $50, you'll pay me the cost of the window replacement of $1,000 if it does get broken within the two year period. If I win, I get $1,000. If you win, I get nothing and you keep the $50.

The guy that takes the $50 has no reserves to assure that he can pay me. I just give him the money based on his word and his reputation that he's paid in the past.

The contract that the bank made is an insurance contract.

The bet that I made is a default swap.

You may recall that it was all over the news last year that unregulated credit default swaps caused the financial meltdown that occurred at the end of last year and caused the demise of Bear Stearns, the bankruptcy of Lehman Brothers, the merger of Merrill Lynch into the Bank of America and the near bankruptcy of AIG, the insurance giant that had to be bailed out by the government to the tune of $180 billion.

How could this be? How could it be in this day of the Securities and Exchange Commission and the vast government regulatory system that we have that a security known as a credit default swap could completely escape scrutiny?

Again, it was the government that caused the mess and now, it is the government that will have to fix it if it can.

To understand how this could happen, a little history is in order.

Back in the late 19th century, a number of sleazy brokerage houses sprang up in New York and around the country. They eventually became known as bucket shops.

What these shops sold were bets on securities. What the customer purchased was a derivative, i.e. a credit default swap in a security or a commodity future.

However, the transaction was not done through an exchange of any kind. It was a bet made with the bucket shop.

The bettor would give a fee to the bucket shop betting that a particular security was going to go down and if it did, then the bucket shop would pay. If it didn't within a defined time, then the bucket shop would win the bet and the bettor would lose and get nothing.

The transaction goes 'in the bucket' and is never executed, thus the term bucket shop.

Without an actual underlying transaction, the customer is betting against the bucket shop operator, not participating in the market.

Alternatively, the bucket shop operator literally 'plays the bank,' as in a gambling house, against the customer.

Some states began banning bucket shops at the end of the 19th century. The federal government followed suit in 1908 after the panic of 1907.

Bucket shops were illegal from 1908 until 2000. Then, Congress changed the law again.

The Congress passed an amendment to the securities laws stating that a credit default swap was exempt from any regulation and the federal law specifically prohibited the states from passing any law to the contrary. Federal preemption governed this area of the law they said.

It was a Republican Congress and a Democratic President, Bill Clinton, who passed this new law.

The result was a sensational give away to Wall Street investors and brokers.

Immediately, large brokerage firms started selling credit default swaps for the very first time. Insurance companies did as well.

The real problem was that these bets were not backed by any reserves. The purchaser of the swap relied solely on the good word and reputation of the seller of the swap.

Also, the purchaser of a swap was not required to have any interest in anything that he was trying to hedge against such as our example of the bank insuring against the window getting broken.

Anyone could buy a swap betting on anything they wanted so long as the house would take the bet.

It is legalized gambling of the worst sort.

This is what happened.

Merrill Lynch for example would sell bonds to raise money to purchase a portfolio of home mortgages with a value of $1 billion.

I have no interest in whether Merrill Lynch is able to pay the bonds on time or not but I still could purchase a credit default swap betting that the value of the bonds will fall below $900 million within two years. I would pay a premium for the swap, say $500,000. If within the two years, the bonds did not fall in value, I would lose my money. If they did, then I would be paid $100 million.

It's just as if the bucket shops of the 19th century were back in business. Only now, they were very big companies like Lehman Brothers and AIG Insurance.

No one knows how many swaps have been sold or how many contracts are outstanding. The estimates have been as high as $60 trillion. However, it could be much higher.

What should Congress do? Should all swaps not held as actual hedges against assets owned by the investor be cancelled?

Would that help put order back in the market or would it be seen as the government interfering with the right of two persons to make a contract?

Should companies like AIG be forced to spin off their credit default swaps to protect the rest of the company?

To a point, this has already occurred. Certainly, the government cannot continue to pay off AIG's bets until they all expire.

One unintended consequence of the bail out was that when the government gave loans to the banks to shore them up, the money went to European banks to pay off the debt from credit default contracts.

Back in March, CBS News reported that some of the biggest recipients of the AIG bailout money were three European banks - France's Societe Generale at $11.9 billion, Germany's Deutsche Bank at $11.8 billion and Britain's Barclays PLC at $8.5 billion.

Is the government responsible because it allowed unregulated betting on securities and thus, it must pay the piper?

Already, some individual investors, mostly hedge fund managers, who bought these swaps have made billions without owning any of the underlying assets. A lot of them don't want to talk about it.

It's time to shut down the bucket shops again just as we did in 1908. This time, hopefully, they'll stay closed.