Credit Default Swaps: Banking on Failure

Michael Stephens | December 13, 2011

Micah Hauptman of Public Citizen has drawn from the work of the Levy Institute’s Marshall Auerback and Randall Wray to put together a concise piece that lays out five core critiques of credit default swaps.  Among the basic problems he highlights is a flaw-riddled process for determining when a CDS pays off:

… there are no bright lines to determine when a CDS payment is triggered. The system for determining when payments should occur is murky, unregulated, and replete with conflicts of interest. For speculators to cash in on their bets and receive CDS payments, there must be a “credit event.” Failure to pay when due is the most common credit event, however a “credit event” can also occur through bankruptcy, a change in interest rate, a change in principal amount, or postponement of interest or principal payment date. But even within these occurrences, there is considerable legal debate over what constitutes an “event.”

Consider the current financial crisis in Greece. The country has experienced distress due to mounting government debt. European officials recently reached a tentative restructuring agreement. Under the agreement, Greece will undergo a strict austerity plan to regain solvency and Greece’s creditors will receive a reduction in their interests. Whether this restructuring agreement constitutes a “credit event” will likely be contested.

Decisions like this as to whether a “credit event” has occurred are made by the International Swaps and Derivatives Association (ISDA) Determinations Committee—but as Hauptman points out, the ISDA committee includes representatives of financial institutions (some of the largest banks and hedge funds) that often have a stake in whether payments are triggered.

Read Hauptman’s piece here.

For those who are paying attention to the meltdown in Europe, credit default swaps are likely to make a dramatic reappearance.  Bloomberg reports, for instance, that European banks are selling CDS on their own member-nation’s debt (via Zero Hedge).  Banking on failure indeed.

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  1. Comment by The Coming Storm in Europe « CitizenVoxFebruary 9, 2012 at 9:55 am   Reply

    […] Finally, problems with credit default swaps on Greek debt may crash onto the scene. Credit default swaps act as “insurance” against a bond’s default. Hedge funds have allegedly bought credit default swaps on Greek debt—likely without buying the underlying debt—so they can get paid and hit a windfall when (not if) Greece ultimately fails. Essentially, they are “Banking on Failure.” Auerback says, “These credit default swaps are like Frankenstein financial products, they shouldn’t be allowed and there should be no reason for the authorities to accommodate these things.” However, it’s still questionable whether credit default swaps on Greek debt will pay. The banks insuring the debt will likely argue the bondholders are taking a “voluntary” haircut, while the swaps holders will say it is voluntary only the way that someone being robbed at gunpoint “voluntarily” hands over money. To complicate things further, the process for determining when credit default swap payments are triggered is “murky, unregulated, and replete with conflicts of interest.” […]

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