Wednesday, July 18, 2012

Determination of Credit Default Payouts in Cases of Partial Default Rigged Like Libor?

Majia here: Propublica has an interesting article about credit default swaps and the decision to payout credit default swaps on Greece's partial debt default in March of 2012. 

I am going to provide some background on credit default swaps before describing how these derivatives can be used to increase the borrowing costs of corporations and governments. 

As I shall demonstrate, credit default swaps can essentially be "weaponized" when they are used to increase borrowing costs beyond what the debtor can afford, forcing the debtor into default, which would thereby allow the payout of credit default swaps.

The ProPublica article explains to us that the committee that makes decisions about payouts of credit default swaps in the event of partial defaults is populated by same agents that benefit from these payouts.

Credit default swaps (CDS) were invented in 1997 by JP Morgan Chase (Prins, 60). CDS are sold by insurance companies to investment and commercial banks alike. They “insure” risky investments, often in excess of the value of the underlying insured investment. CDS were not regulated and companies that issued them typically failed to hold adequate reserves against outstanding contracts. American Insurance General (AIG) sold credit default swaps to the large investment and commercial banks, among other buyers, on securities (particularly CDOs) derived from mortgages.  The originate-to-distribute lending model that permeated nearly all forms of credit instruments made debt a highly profitable commodity while distributing “risk” internationally as investors around the world purchased bonds and derivatives created out of pooled debt. 
For the most sophisticated players, the risk of default on the debts underlying the securities was hedged by credit default swaps. Indeed, betting on debt default using a credit default swap could be more profitable than holding and trading intact debt-based securities. Credit default swaps are a derivative that succeeds with financial volatility. By 2008 the market for credit default swaps was valued at $45.5 trillion (Prins, p. 60).
Jim Rickards, a financial analyst who consults to the U.S. government on financial security, described the “weaponization” of finance (2010b) as banks and hedge funds in 2010 (naked) shorted sovereign debt (bonds) in Europe in what Rickards termed as “attacks on sovereign credit” (2010a) using credit default swaps. Rickards (2010a) explained that derivatives trades such as CDS allow speculators to short companies or nations on electronic exchanges with no money down: “You can attack a country with no money, no money down, just create a credit default swap out of thin air.” The interest rates a country or company must pay consumers of its bonds are determined in part by the number and valuation of credit default swaps predicting that country/company's default. 
Greece was reportedly the subject of such an attack on sovereign credit. The interest rates Greece had to pay to issue new bonds and roll over its debt were being driven up by the amount of credit default swaps outstanding predicting its default. Greece couldn't afford those interest rates and couldn't print money to cover them because of its status within the Eurozone. So, Greece had a partial default of its debt in early 2012.
This type of situation was predicted. Rickards observed in 2010 that the European Union’s $1 trillion dollar rescue package for nations facing exorbitant interest rates for refinancing their debts (due to these types of attacks) would easily be outmaneuvered by the banks and hedge funds, which are capable of naked shorting Greek bonds with essentially no financial backing. The deliberate and punitive (naked and legitimate) short selling of bonds or derivatives by acquisitive capitalists who lack national allegiance has been described by Max Keiser as “financial terrorism” (2010a).
Fast Foward to Greece's partial default on its sovereign bonds early 2012. The big question in Feb and early March of 2012 was will Greece's partial default result in a payout of credit default swaps on Greek debt? 
The answer: Greek Credit-Default Swaps Are Activated. Peter Eavis March 9, 2012.

Majia here: According to the reports I found, AIG was likely to be the number one agent exposed to the liabilities posed by the payout of credit default swaps. One does not have to actually hold Greek bonds to purchase Greek credit default swaps. Here is an excerpt from an article written by the
New York Times back in June 2011 on exposure to a Greek default:

[excerpted] "The looming uncertainties are whether these contracts — which insure against possibilities like a Greek default — are concentrated in the hands of a few companies, and if these companies will be able to pay out billions of dollars to cover losses during a default. If there were a single company standing behind many of these contracts, that company would be akin to the American International Group of the euro crisis. The American insurer needed a $182 billion federal bailout during the financial crisis because it had insured the performance of mortgage bonds through derivatives and could not pay on all of them.

 So, JP Morgan (which helped Greece hide its debt) probably holds lots and lots of credit default swaps on Greek debts, but may very well hold NO Greek Sovereign Bonds. The decision to pay out on Greek credit default swaps will mean that AIG and other insurers will be paying to agents like JP Morgan who bet on, and may have helped exacerbate, Greece's default. The US government will once again have to come to AIG's aid to make good these unregulated credit default swap agreements that AIG sold without reserves.


Majia here: What was missing from the previous discussions of the decision for activation of the credit default swaps was a description of the committee that made the decision. Pro Publica provides us that information now and with it comes many questions about institutionalized conflicts of interest.
Like Rate-Fixing Scandals? You’ll Love the Credit Default Swap Market. ProPublica, July 18, 2012, 12:15 p.m by Jesse Eisinger

[Excerpted] Decisions about when a swap pays out are made by a trade group called the determinations committee [1] of the International Swaps and Derivatives Association.... 

The determinations committee has 15 members, 10 of which are the major dealers in credit default swaps, the giant banks that are effectively permanent members. One criterion for dealer members is that they trade a certain amount of derivatives. In the wake of the 2008 financial crisis, there are fewer such firms, and they have consolidated their influence and power over our capital markets.

The committee operates as a quasi-Star Chamber or cartel. It makes decisions without having to publish its reasoning and almost never has. There isn't any appeal process. The committee itself says it isn't bound by precedent

The biggest concern is that there's no prohibition against committee members deciding cases in which they may well have an economic interest. There is no recusal process. Indeed, it is almost impossible for the major dealers to not have a stake in the outcomes, since they are the major dealers....

[end excerpt]

Majia here: So, now we know why the Determinations Committee ruled in favor of a pay-out on Greek credit default swaps. They no doubt benefited from the payout.

Keiser M. [with S. Herbert] (2010a, April 19). Max explains Blankfein’s financial terrorism to radio listeners in Moscow. MaxKeiser.Com [on-line]. Available:
Prins, Nomi. It Takes a Pillage: An Epic Tale of Power, Deceit, and Untold Trillions. John Wiley, 2011.
Rickards, J. (2010a, May 22). Interviewed on King World News [on-line]. Available:
--(2010b, May 25). Interviewed on the Keiser Report 45: Goldman Sachs, undeclared enemy of the state. MaxKeiser.Com [on-line]. Available:

Background on the Payout of Greek Credit Default Swaps

AIG will be exposed in the event of a ruling in favor of payouts.

Background on Credit Default Swaps as Weapon Against Greece
Background on the Use of Derivatives in Causing the Financial Crisis

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