Goldman Derivatives’ Ugly Double Role in Greek Tragedy

Goldman Derivates Collateral

27 February 2010. By David Caploe PhD, Chief Politics Economist, EconomyWatch.com.

27 February 2010. Through David Caploe PhD, Chief Political Economist, EconomyWatch.com.

Even though we have some actual questions regarding significant aspects of Warren Buffet’s relations with Goldman Sachs, we have usually appreciated his outspokenly negative portrayal of one of his erstwhile colleagues’ preferred playthings – derivatives – as “economic weaponry of mass destruction.”

In our view, the nuclear metaphor is actually entirely apt, since – once these things DO explode – there will be two aspects: the actual immediate “blast effects” and the long-range “fallout” – each of which will cause intense suffering, otherwise death, for individuals and establishments coming in contact with them. Remember that 100 million more people are hungry thanks to the Financial Crisis.

Despite his and our consistent warnings concerning the potential dangers of these totally 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 utilization of derivatives can, in this case, exacerbate an already screwed-up situation, and, in the case of the US housing market, create a issue when none previously existed – which is why Americans, Asians and others, and not only the directly affected Men and women, should pay careful attention to the unfolding Greek tragedy.

In this regard, it is nice to see the New York Occasions beginning to play a more positive role in making sure the consequences of those “economic nuclear devices” are clear towards 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 fairly few people are going to see them.

Now, however, even they are seeming to realize the detrimental effects of the actual “double game” they and most additional mainstream media organizations regularly 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 web is destroying daily the company plan by which they have operated not less than 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 2 major pieces the Times did not [for a change, whenever it comes to Goldman] “conceal in plain sight”, but actually put in prominent places, and maintained for a while, on their web site.

The first appeared on February 24, as well as was notable in three ways:

1.     

It made clear the structural similarities in the methods used by Goldman Sachs and others in how these people handled BOTH the Greece “sovereign debt” situation AND the US housing market.

2.   

It did a nice job of explaining the way the derivatives in question – credit-default swaps – actually worked, again, both in relation to A holiday in greece and the still-waiting-for-the-other-shoes-to-drop-mortgage-backed-securities-MBS- American International Team [AIG] scandal, and

3.   

Perhaps most explosively – which is saying something – it revealed how Goldman, JP Morgan Chase contributing to a dozen other banks involved with “helping” Greece through the – again, un-regulated and totally non-transparent – use of derivatives had simultaneously backed the heretofore almost unknown company that had created an index that enabled the market players to wager on whether Greece and other European nations would go bust.

Let’s start with the architectural similarities:

Bets by some of the same banking institutions that helped Greece shroud its mounting debts may actually now be pushing the nation nearer to the brink of financial ruin.

Echoing the type of trades that nearly toppled the United states International Group, the increasingly popular insurance coverage against the risk of a Greek default is making it tougher for Athens to raise the money it needs to pay its bills, according to traders and money managers.

These contracts, referred to as credit-default swaps, effectively let banks and protect funds wager on the financial equivalent of a four-alarm fire: a default by a company or, in the case of Greece, a whole country. If Greece reneges on it’s debts, traders who personal these swaps stand to profit.

“It’s like buying fire insurance on your neighbor’s house — a person create an incentive to burn on the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich. …

If that sounds familiar, it should. Critics of those instruments contend swaps led to the fall of Lehman Brothers.

But until recently, there was small demand for insurance on federal government debt. The possibility that a created country could default upon its obligations seemed distant.

So how is it that these credit-default swaps – in whose acronym CDS became well-known throughout Black September 2008, despite the fact that few understood what they intended, even fewer how they really worked – operate,

making it possible for companies such as Goldman Sachs and others to simultaneously “help” their clients acquire loan money, while making sure they on their own would profit, in some ways even more, if their clients actually couldn’t pay back the money they were assisting them secure ???

The underlying theory of a credit-default swap is fairly simple, once it’s explained clearly enough to “outsiders.”

At the same time frame banks are loaning huge amounts of money to either companies or even, as in this case, countries, they want to make sure their loans / investments are safe.

In order to do that, these people take out insurance, usually with a large enough insurance company – say, AIG – able to stand up to the pressure should the worst happen – for example, either the company goes bankrupt or country defaults on its obligations.

Unfortunately, whether intentionally or not, the existence of these credit score default swaps makes more and 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 reasons uknown, a country like Greece begins to appear it’utes going to have problems paying its debts, banks and others who have already loaned / committed to that country rush to buy these credit default swaps Or 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 must pay off its existing obligations.

As it might be harder for them to find the money they need to pay their debts, the potential 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 blow up in a matter of hours:

Creditors become concerned and panicked about losing their money – leading them to become active within the credit default market.

This reduces available lending sources Or increases interest rates for the nation wishing to borrow, hence producing default more likely.

This leads to even more demand from creditors – and hence higher prices for – the CDSs / default insurance policies,

in change making it ever more expensive and much more difficult for the country to find the cash to pay its debts – etc etc etc etc, as Yul Brynner said in The King and I.

While obviously disturbing for all parties involved, the basic dynamic really isn’t that hard to understand.

It’s the next action that makes the whole process grisly and nasty – for this is where the “double game” banks / insurance providers / countries were actively playing got truly vicious.

As Greece’s personal finances has worsened, undermining the dinar, the role of Goldman Sachs and other major banks in masking the true extent of the country’s issues [through the use of other complex derivatives] has attracted criticism from European leaders.

And, once 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 which were pre-conditions for joining the Eurozone.

But before that issue became obvious, a little-known company backed by Goldman, JP Morgan Chase contributing to a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

So let’utes be clear: at the same time Goldman et aussi al were using complex derivatives to help Greece, Italy and perhaps others AVOID the government deficit limits that were supposed in order to insure credit-worthiness for entrance into the Eurozone,

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 really 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 are able to say about their ethics – that isn’t much – you’ve got to admire the smarts on these guys.

They weren’t stealing through Peter to pay Paul – they were stealing from Peter As well as Paul to pay themselves.

But let’s let the New York Times tell the story they, after all, not just documented, but actually, for a change, made available on their website at a time people when people may really see it.

A little-known company supported by Goldman, JP Morgan Chase and about twelve other banks had created an index that enabled market players to bet upon whether Greece and other Western nations would go bust line.

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 addresses 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 strike $109.3 billion, up from $52.9 billion in January.

Markit collects a flat fee by licensing agents to trade the index.

Trading in Markit’s sovereign credit derivative catalog … helped to drive up the cost of insuring Greek debt, as well as, in turn, what Athens must pay to gain access to money.

The cost of insuring $10 million of Ancient greek bonds, for instance, rose to more compared to $400,000 in February, up from $282,Thousand in early January.

On several days at the end of January and early Feb, as demand for swaps protection soared, investors in Greek ties fled the market, raising uncertainties about whether Greece may find buyers for coming bond offerings …

And who are the participants in this little “double game” ??? Surprise, surprise:

European banks including the Swiss giants Credit Suisse and UBS, France’s Société Générale as well as BNP Paribas and Deutsche Bank of Germany have been among the heaviest purchasers of swaps insurance, according to investors 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 appears at $43.2 billion.

Trading in credit-default trades linked only to Greek debt has also surged, but is still smaller than the country’s real 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 trades trading.

Whether this cozy little arrangement will continue remains not clear, since – either through ignorance, which would be unpardonable, or collusion, which would end up being even worse – US government officials tend to be FINALLY starting to “make inquiries” into this sordid and almost incredible situation.

It remains unclear precisely how serious this “inquiry” is going to be, however the sudden motivation could hardly become more clear. Certainly European officials have indicated for several weeks awareness of the whole history of Goldman’utes involvement with several of the Membership Med / PIGS countries.

But this wasn’t until the day after the Times story appeared that recently re-appointed Fed chairman Ben Bernanke introduced the Fed would be looking into Goldman’s role in BOTH finishes of the double game they’re been playing in the Greek fiasco.

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 comprehensive in scores of media resources – even in the New York Times, albeit at moments once they could easily be “hidden in plain sight”.

But as soon as a Times tale about the sleazy role of derivatives appeared during the middle of the function week – as opposed to the beginning of a long vacation weekend, which is where they’d been placed before –

the response was immediate, if albeit barely confidence-inspiring, given the Greenspan / Bernanke Fed’s apparent willingness over the last several decades to close its eyes nearly completely until absolutely instructed to look at anything “unusual” – a trait shared with the equally somnolent Securities & Exchange Commission.

If I had been 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, may well be a different story, especially since they will be looking to pin blame for this disaster on anyone BUT themselves and their own derelict establishments and practices, and Goldman makes the perfect villain, for all kinds of – mostly legitimate – reasons.

As with regard to Greece, the outlook continues to be grim, heading towards dire:

In a sign of the challenges their country faces, Greek officials called off a planned trip to the United States and Asia aimed at interesting new investors in its bonds due to a lack of demand …

Greece faces a critical test next week, when it will try to raise about 3 billion pounds ($4 billion), through an issue of 10-year bonds.

But with threats of the downgrade to its sovereign debt pending, investors say Greece would need to spend a whopping 7 percent rate of interest just to get people to buy.

That is nearly a percentage point more than the rate investors received in the previous Ancient greek bond sale, in The month of january, and a full 3 percentage points more than Greece’s borrowing cost before the current crisis. …

The rise in investor skepticism has brought Greece to adopt a new funding strategy.

Instead of selling debt through community auctions, where the danger of a failed offering could further unnerve markets, it has gone straight to institutional investors, sounding them out in one-on-one meetings, mostly in London.

Bankers and analysts in Athens say there is a discussion 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 field wage cuts — is introduced, in the hope that such steps will result in lower financing expenses.

But a more dire view is already taking hold, according to some bankers, as investors fret which Greece may simply not be able to cover 20 billion euros associated with debt coming due within 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 plan funds and insurance companies that are already nursing losses from the 8-billion-euro Greek bond issue within January that was hit through the recent market downturn.

Guess they weren’t able to get into that personal little Markit to make sure they got the right credit-default swaps.

Maybe next time, they’ll contact Goldman before they start giving away their money. Without doubt, they’ll receive a friendly wedding reception – they should just be sure to keep their hands on their wallets all the time, literally and figuratively.

David Caploe PhD

Chief Political Economist

EconomyWatch.com