March 11, 2010

How can you tell a European financial regulator from an American financial regulator? The European thinks Credit Default Swaps (CDS) are very dangerous weapons; that the bankers selling the CDS tricked Greece and pushed that country into a debt crisis; that CDS has the potential to melt down the EU. American regulators think CDS is a commission generating tool that allows financial firms to generate big profits while reducing risk. A battle is brewing.

The Europeans want to ban some derivatives, specifically sovereign CDS (bets that a country, such as Greece, Spain, Portugal, or Italy will go into default). Greece’s prime minister says speculators are using swaps to bet against his country.

CDS is a type of insurance but it requires no proven reserves be set aside for claims, and it does not require that the person buying the insurance has an insurable interest. If a wife buys insurance on her husband, she has insurable interest. If a doctor tried to buy insurance on his patients, he would not have insurable interest; he may be tempted to kill off a few patients in order to collect on the insurance. That is not something a good doctor would do, but why tempt fate?

European regulators are concerned that, unlike the good wife or the good doctor, the bankers would try to destroy the economies of various nations in order to collect on the CDS “insurance”.

Here’s what the bankers say, specifically Lloyd Blankfein, CEO of Goldman Sachs, “If we simply ban customized derivatives to satisfy the perception that everything associated with these markets is bad, we run the risk of limiting… business investment and, ultimately economic growth.” Sounds a little bit like a threat, doesn’t it?

It’s not quite that simple. The way the derivatives markets are set up. Bond prices and other debt instrument prices are directly linked to credit default swaps, which (at least in theory) support the prices. An “insured” or hedged investment is worth a higher price than an uninsured investment. Think of it as paying a premium for a guarantee. If the CDS guarantee is banned, there will be a rush to sell CDS prior to the ban; the price of bonds and other debt instruments will be pushed lower because of the lack of a guaranteed hedge.

Investors hold a little over $400 billion worth of outstanding Greek bonds and about $9 billion in insurance against that debt through Credit Default Swaps. That $9 billion in CDS insurance has nowhere near enough reserves to pay off in the event of Greek default. But it doesn’t stop there. Greek debt is tied to the debt of the European Union. Greece is now facing a second wave of strikes. The Greek GDP is going to fall far short of already diminished expectations. If Greece defaults on its debt, then EU debt could default or, at least rocket in price. It could get ugly quick. Remember the collapse of Lehman?

So we have CDS insurance that can’t pay off to uninsurable interests. If we try to ban sovereign CDS derivatives now, everything collapses. If the Greeks default, the house of cards is exposed and everything collapses. These derivatives products were a bad idea from the start, but the reality is that they are in place now, the time bomb is ticking, and there is no viable exit strategy. It reminds me of the song “Hotel California”: “You can check out any time you want but you can never leave.”

Sinclair Noe

Eat the Bankers

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