Saturday, March 13, 2010

Washington Must Ban U.S. Credit Derivatives: Games and Gold (Two Parts)

Posted in the Huffington Post by Janet Tavakoli:

Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Failure to act now will only mean the U.S. will be forced to act after these "financial weapons of mass destruction" levy heavy casualties. These obligations now settle in euros, but the end game is to settle them in gold. This is so ripe for speculative manipulation that you might as well cover the U.S. map with a bull's-eye.

Credit default swaps are not insurance. If you buy fire insurance on your home, you must own the house. If you buy credit protection on the United States, however, you do not need to own U.S. Treasury bonds. If your protection gains value after you buy it -- not because the U.S. defaults, but because of market mood changes -- you can resell that protection and make a profit.

Lower credit risk means a lower price for protection. Zero implies zero risk. The higher the basis points, the higher the implied risk. When U.S. credit default swaps were first introduced, the price of protection was around two basis points. According to Bloomberg, the price for five-year protection was around 38 basis points (per annum) on Friday. But the price in the over-the-counter market -- where this stuff actually trades -- was almost double or around 75 basis points.

Since most traders in U.S. credit default swaps don't think the U.S. will default any time soon, why are they trading U.S. credit default swaps? They are speculating on price movements the way a day trader buys and sells stocks to speculate on stock price movements.

Volume in U.S. credit default swaps is relatively small, but it can explode rapidly, just as volume expanded rapidly for credit default swaps on mortgage debt in 2006 and 2007.

Speculators Want U.S. CDS Payoffs in Gold

Remember AIG? When prices moved against AIG on its credit default swap contracts, AIG owed cash (collateral) to its trading partners. AIG paid billions of dollars and owed billions more when U.S. taxpayers bailed it out in September 2008.

U.S. credit default swaps currently trade in euros. After all, if the U.S. defaults, who will want payment in devalued U.S. dollars? The euro recently weakened relative to the dollar, and market participants are calling for contracts that require payment in gold. If they get their way, speculators on the winning side of a price move will demand collateral paid in gold.

The market can create an unlimited number of these contracts very rapidly. The U.S. wouldn't have to ever default to trigger a major disruption in the gold market. Spreads (or prices) on the credit default swaps could simply move based on "news," and demand for gold would soar.

If this speculation drives up the price of gold, and the available gold supply becomes limited, are you willing to post your children as collateral? I am pushing the point so that we put a stop to this before it is too late.

Global Disaster in the Making

More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*

The European Union has its own challenges. German Chancellor Angela Merkel recently called for limits on credit derivatives on Greece, since the European Union is concerned about misuse of credit derivatives for speculation. Chancellor Merkel did not go far enough.

World leaders shouldn't merely ask for limits on sovereign credit derivatives. They should demand a ban on all sovereign credit default swaps.

Part II:

In an earlier post, I wrote that Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Credit defaults swaps on the United States currently settle in euros, but there is talk of creating new contracts calling for settlement in gold. This is just a trial balloon discussion at the moment, but it is one that Congress should immediately deflate along with all credit derivatives on the United States.

Most traders in U.S. credit default swaps don't think the U.S. will default as long as we have money printing presses, so they are speculating on price movements. If speculators manage to get contracts to settle in gold, speculators on the winning side of a price move will demand collateral paid in gold.

Gold is Collateral on the London CME

Presenting gold to satisfy demands for Performance Bond Collateral is already allowed on the London CME in a limited way since October 2009. [Hat tip to Hilary Till, co-founder of Premia Capital.] This is an excerpt from the announcement:

CME Clearing is introducing an enhancement to the existing Performance Bond Collateral schedule. Effective October 19, 2009, firms will be able to post physical gold to CME Clearing to cover non-segregated (NSEG) Performance Bond requirements. Initially, gold will be able to be posted to JPMorgan Chase Bank in London, England. In the near future, we hope to add additional depositories.


There will be a firm asset limit of $200 million. These guidelines are subject to change and will be evaluated on a regular basis.


Sovereign Credit Default Swap Contracts: Tower of Babble

The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.

J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

Regulators "Can't Find" Evidence of Market Manipulation

European regulators said they saw no evidence of manipulation in the Greek credit default swap market because they examined DTCC data. DTCC doesn't capture all trades. Regulators would have found evidence of the rampant manipulation in the U.S. mortgage backed securities market, either, since those trades were not captured on any clearing exchange. Moreover, already flawed "ISDA standard" documentation does not have to be used for opaque credit derivatives, including those that may reference sovereign debt. Allan Sloan at the Washington Post asked the right questions:

How much of this stuff do the Street people own? Where is it? What kind of securities has it been pushed into? No one knows. The one thing you can bet on, though, is that unraveling it all is going to be horribly complicated. Why? Because for Wall Street, complexity equals profitability.


I am not against covered short selling or puts, and some short sellers have done better work than main stream media in uncovering accounting manipulation and over-borrowing. (Click here to see David Einhorn's early warnings about Lehman Brothers.) But the credit default swap market has a history of manipulation, and we are in the middle of a global financial crisis. Speculators can potentially destabilize a country or a company that's already in trouble.

Time for Reform is Overdue

More than a year has passed since former Treasury Secretary Henry Paulson went to Congress in September 2008 to plead for special powers and TARP money to bail out U.S. financial institutions. Yet there has been no meaningful financial reform.*

Lehman was not alone in fudging its accounting and over-borrowing. All of our legacy investment banks: Lehman Brothers, Goldman Sachs, Morgan Stanley, Bear Stearns, and Merrill Lynch had borrowed too much money, all of them used gimmicks to disguise debt, and all of them--including Goldman Sachs--would have gone under in 2008 without the bailouts.

World leaders should not be surprised that many countries also disguise debt and fudge their accounting. A good first step to reform of the financial system is to take away financial instruments that are ripe for abuse, starting with a ban on all sovereign credit default swaps.

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