Goldman Derivatives’ Ugly Double Role in Greek Tragedy
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27 February 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
27 February 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
27 February 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
27 February 2010. By David Caploe PhD, Chief Political Economist, EconomyWatch.com.
Even though we have some real questions regarding significant aspects of Warren Buffet’s relations with Goldman Sachs, we have always appreciated his outspokenly negative characterization of one of his erstwhile colleagues’ favorite playthings – derivatives – as “economic weapons of mass destruction.” [br]
In our view, the nuclear metaphor is entirely apt, since – once these things DO explode – there will be two aspects: the immediate “blast effects” and the long-range “fallout” – each of which will cause intense suffering, if not death, for individuals and institutions coming in contact with them. Remember that 100 million more people are hungry thanks to the Financial Crisis.
Despite his and our consistent warnings about the potential dangers of these completely un-transparent and un-regulated instruments, the keyword until now has been “potential”.
But the situation in Greece begins to outline, in all too painful detail, how the use of derivatives can, in this case, exacerbate an already screwed-up situation, and, in the case of the US housing market, create a problem when none previously existed – which is why Americans, Asians and others, and not only the directly affected Europeans, should pay careful attention to the unfolding Greek tragedy. [br]
In this regard, it is nice to see the New York Times beginning to play a more positive role in making sure the consequences of these “economic nuclear devices” are clear to the public. To be sure, the Times has done some landmark reporting on the destructive effects of these and other instruments, especially in the hands of Goldman Sachs. But, as we have pointed out, they have consistently “hidden those stories in plain sight” by releasing them at times when relatively few people are going to see them.
Now, however, even they are seeming to realize the detrimental effects of the “double game” they and most other mainstream media organizations consistently play with major advertisers and other powerful forces in society, whose activities they must expose in order to maintain “journalistic credibility” at a time when the Internet is destroying daily the business model by which they have operated for at least two hundred years without cutting off either much-needed revenues or equally-crucial access to sources within these powerful groups.
It was therefore somewhat encouraging – at least from a “public enlightenment” point of view … the substance is truly frightening – to read two major pieces the Times did not [for a change, whenever it comes to Goldman] “hide in plain sight”, but actually put in prominent places, and kept up for a while, on their web site.
The first appeared on February 24, and was notable in three ways:
1. It made clear the structural similarities in the tricks used by Goldman Sachs and others in how they handled BOTH the Greece “sovereign debt” situation AND the US housing market.
2. It did a nice job of explaining how the derivatives in question – credit-default swaps – actually worked, again, both in relation to Greece and the still-waiting-for-the-other-shoes-to-drop-mortgage-backed-securities-MBS– American International Group [AIG] scandal, and
3. Perhaps most explosively – which is saying something – it revealed how Goldman, JP Morgan Chase and about a dozen other banks involved in “helping” Greece through the – again, un-regulated and totally non-transparent – use of derivatives had simultaneously backed a heretofore almost unknown company that had created an index that enabled these same market players to bet on whether Greece and other European nations would go bust.
Let’s start with the structural similarities:
[quote]Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin.
Echoing the kind of trades that nearly toppled the American International Group, the increasingly popular insurance against the risk of a Greek default is making it harder for Athens to raise the money it needs to pay its bills, according to traders and money managers.
These contracts, known as credit-default swaps, effectively let banks and hedge funds wager on the financial equivalent of a four-alarm fire: a default by a company or, in the case of Greece, an entire country. If Greece reneges on its debts, traders who own these swaps stand to profit.
“It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich. …
If that sounds familiar, it should. 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.
[/quote]So how is it that these credit-default swaps – whose acronym CDS became well-known during Black September 2008, even though few understood what they meant, even fewer how they actually worked – operate,
making it possible for companies like Goldman Sachs and others to simultaneously “help” their clients acquire loan money, while making sure they themselves would profit, in some ways even more, if their clients actually couldn’t pay back the money they were helping them secure ???
The underlying principle of a credit-default swap is fairly simple, once it’s explained clearly enough to “outsiders.”
At the same time banks are loaning huge amounts of money to either companies or, as in this case, countries, they want to make sure their loans / investments are safe.
In order to do that, they take out insurance, usually with a large enough insurance company – say, AIG – able to withstand the pressure should the worst happen – ie, either the company goes bankrupt or country defaults on its obligations.
Unfortunately, whether intentionally or not, the existence of these credit default swaps makes ever more likely the eventuality they are allegedly in place to make sure doesn’t occur – that is, a bankruptcy or default.
The result, therefore, is a vicious cycle.
If, for whatever reason, a country like Greece begins to appear it’s going to have problems paying its debts, banks and others who have already loaned / invested in that country rush to buy these credit default swaps / CDSs / default insurance policies / whatever you want to call them.
This increased demand creates a rise in the price of these default insurance policies, which is hardly surprising.
However, once the price of the insurance policies starts to rise, it – equally unsurprisingly – becomes more expensive, if not impossible, for the country in question to find the money it needs to pay off its existing obligations.
As it becomes harder for them to find the money they need to pay their debts, the possibility of a default – the very outcome the CDSs / default insurance policies were supposed to help guard against – becomes increasingly likely.
Given the speed of modern financial transactions, this vicious cycle can explode in a matter of hours:
Creditors become worried and panicked about losing their money – leading them to become active in the credit default market.
This decreases available lending sources / increases interest rates for the country wishing to borrow, hence making default more likely.
This leads to even more demand from creditors – and hence higher prices for – the CDSs / default insurance policies,
in turn making it ever more expensive and more difficult for the country to find the money to pay its debts – etc etc etc etc, as Yul Brynner said in The King and I.
While obviously unsettling for all parties involved, the basic dynamic really isn’t that hard to understand.
It’s the next step that makes the whole process grisly and nasty – for this is where the “double game” banks / insurance companies / countries were playing got truly vicious.
[quote]As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems [through the use of other complex derivatives] has drawn criticism from European leaders.
[/quote]And, as we noted in discussing this aspect of the situation on February 16, making big bucks for themselves in the process of helping Greece and Italy avoid the allegedly strict “deficit” limits that were pre-conditions for joining the Eurozone.
But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.
they were simultaneously creating an index that would enable them to bet on which of their own clients might, in fact, go into default –
as a result of the very help they were giving them, using other complex derivatives,
in avoiding the deficit limits that were supposed to preclude this sort of default.
Whatever you can say about their ethics – which isn’t much – you’ve got to admire the smarts on these guys.
They weren’t stealing from Peter to pay Paul – they were stealing from Peter AND Paul to pay themselves.
But let’s let the New York Times tell the story they, after all, not just reported, but actually, for a change, made available on their website at a time people when people might really see it.
[quote]A little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.
Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps …
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.
And as worries about those countries’ debts moved markets around the world in February, trading in the index exploded.
In February, demand for such index contracts hit $109.3 billion, up from $52.9 billion in January.
Markit collects a flat fee by licensing brokers to trade the index.
Trading in Markit’s sovereign credit derivative index … helped to drive up the cost of insuring Greek debt, and, in turn, what Athens must pay to borrow money.
The cost of insuring $10 million of Greek bonds, for instance, rose to more than $400,000 in February, up from $282,000 in early January.
On several days in late January and early February, as demand for swaps protection soared, investors in Greek bonds fled the market, raising doubts about whether Greece could find buyers for coming bond offerings …
[/quote]And who are the participants in this little “double game” ??? Surprise, surprise:
[quote]European banks including the Swiss giants Credit 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 who asked for anonymity because they were not authorized to comment publicly.
That is because those countries are the most exposed. French banks hold $75.4 billion worth of Greek debt, followed by Swiss institutions, at $64 billion, according to the Bank for International Settlements. German banks’ exposure stands at $43.2 billion.
Trading in credit-default swaps linked only to Greek debt has also surged, but is still smaller than the country’s actual debt load of $300 billion.
The overall amount of insurance on Greek debt hit $85 billion in February, up from $38 billion a year ago, according to the Depository Trust and Clearing Corporation, which tracks swaps trading.
[/quote]Whether this cozy little arrangement will continue remains unclear, since – either through ignorance, which would be unpardonable, or collusion, which would be even worse – US government officials are FINALLY starting to “make inquiries” into this sordid and almost unbelievable situation.
It remains unclear just how serious this “inquiry” is going to be, but the sudden motivation could hardly be more clear. Certainly European officials have indicated for months awareness of the whole history of Goldman’s involvement with several of the Club Med / PIGS countries.
Which, of course, underlines our on-going point about the crucial role of the media in today’s economedia © world. It’s not as if Goldman’s activities haven’t been detailed in scores of media sources – even in the New York Times, albeit at moments when they could easily be “hidden in plain sight”.
But as soon as a Times story about the sleazy role of derivatives appeared during the middle of the work week – as opposed to the beginning of a long holiday weekend, which is where they’d been placed before –
the reaction was immediate, if albeit hardly confidence-inspiring, given the Greenspan / Bernanke Fed’s evident willingness over the last several decades to close its eyes almost completely until absolutely forced to look at anything “unusual” – a trait shared with the equally somnolent Securities & Exchange Commission.
If I were Goldman, I wouldn’t be too concerned about American officialdom – they are so deeply implicated in the whole sordid mess they risk a complete collapse of whatever shred of legitimacy they may still retain.
The Europeans, though, might be a different story, especially since they will be looking to pin blame for this disaster on anyone BUT themselves and their own derelict institutions and practices, and Goldman makes the perfect villain, for all kinds of – mostly legitimate – reasons.
As for Greece, the outlook remains grim, heading towards dire:
[quote]In a sign of the challenges their nation faces, Greek officials called off a planned trip to the United States and Asia aimed at interesting new investors in its bonds because of a lack of demand …
Greece faces a critical test next week, when it will try to raise about 3 billion euros ($4 billion), through an issue of 10-year bonds.
But with threats of a downgrade to its sovereign debt looming, investors say Greece would need to pay a whopping 7 percent interest rate just to get people to buy.
That is almost a percentage point more than the rate investors received in the previous Greek bond sale, in January, and a full 3 percentage points more than Greece’s borrowing cost before the current crisis. …
The rise in investor skepticism has led Greece to adopt a new financing strategy.
Instead of selling debt through public auctions, where the danger of a failed offering could further unnerve markets, it has gone directly to institutional investors, sounding them out in one-on-one meetings, mostly in London.
Bankers and analysts in Athens say there is a debate within the Finance Ministry as to whether the government should go to the market now, or wait until a new menu of changes — like more taxes and further public sector wage cuts — is announced, in the hope that such measures will result in lower financing costs.
But a more dire view is already taking hold, according to some bankers, as investors fret that Greece may simply not be able to cover 20 billion euros of debt coming due in April and May, and 53 billion euros for all of the year.
It seems unlikely that such a quantity can be raised from investors — many of them conservative pension funds and insurance companies that are already nursing losses from the 8-billion-euro Greek bond issue in January that was hit by the recent market downturn.
[/quote]Guess they weren’t able to get into that private little Markit to make sure they got the appropriate credit-default swaps.
Maybe next time, they’ll call Goldman before they start giving away their money. No doubt, they’ll receive a friendly reception – they should just be sure to keep their hands on their wallets at all times, literally and figuratively.
David Caploe PhD
Chief Political Economist
EconomyWatch.com
