Complicity and camouflage over credit-default swaps

Credit-default swaps are a no-lose financial mechanism which has made some people very rich. But it looks as if some of those people kept quite about impending doom in order to do so. What are credit-default swaps, how did they contribute to the crisis and who will foot the bill? 

Reuters

What are credit-default swaps?

Credit-default swaps (CDS) allow banks and hedge funds to take bets on a default by a company or even an entire country. If the borrower fails to pay, traders - or speculators, as you may prefer to call them - who own these swaps stand to profit. These CDS are supposedly insurance against borowers being unable to reimburse.

What have they got to do with the Greek crisis?

With Greece’s financial condition worsening, EU leaders are blaming Goldman Sachs and other banks for masking the true extent of the country’s problems. But even before Greece’s problems became visible, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled speculators to bet on whether Greece and other European countries would go bust.

Are speculators to blame?

Some European leaders have blamed financial speculators for worsening the crisis. France’s Finance Minister, Christine Lagarde is recommending tighter regulation, saying that a few players dominated this sector. The cost of insuring 10 million dollars of Greek bonds, for instance, rose to more than 400,000 dollars in February, up from 282,000 dollars in early January. The overall result it to make it difficult for Greece to raise money by selling government bonds.

Did anyone profit?

The Markit index is made up of the 15 most heavily traded credit-default swaps in Europe and covers other troubled economies like Portugal and Spain. As worries about those countries’ debts moved markets around the world in February, trading in the index exploded.

European banks including the Swiss giants Crédit Suisse and UBS, France’s Société Générale and BNP Paribas and Deutsche Bank of Germany have been among the heaviest buyers of swaps insurance, according to traders and bankers speaking anonymously to the media.

Why did banks bet against Greece?

Critics of these instruments contend swaps contributed to the fall of Lehman Brothers. But, until recently, there was little demand for insurance on government debt. The possibility that a developed country could default on its obligations seemed remote. As a result, many foreign banks that held Greek bonds or entered into other financial transactions with the government did not hedge against the risk of a default. Now, they are scrambling for insurance.

Since these banks had inside knowledge that Greece's financial position was much less secure than it appeared, being good opportunists, they went out and bought credit default swaps (insurance against default) on Greece's debt.

They thus made big fees setting up the scheme and stand to benefit if the scheme falls apart.

Who was the unwitting sucker to take the bet?

Probably multiple issuers, but it looks like the brainiacs at the giant American Insurance Group (AIG) was among them. The US now owns 80 per cent of AIG. So the American taxpayer would be on the hook in the case of Greece's default.

So, if Greece gets closer to default, the US must either bail out Greece to avoid losses at AIG, or just step up and bail out AIG yet again. Once again, the financial industry wins, and the taxpayers lose.