Goldman Derivatives’ Ugly Double Role in Greek Tragedy

Feb. 27, 2010 - PRLog -- 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.”

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.

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:

   

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.


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 thesecredit 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,

Read the rest of this article, go to EconomyWatch.com:

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