Congress should act immediately to abolish
credit default swaps on the United States,
because these derivatives will foment
distortions in global currencies and
gold. Failure to act now will only mean
the U.S. will be forced to act, after
these “financial weapons of mass
destruction” levy heavy casualties.
These obligations now settle in euros,
but the end game is to settle them in
gold. This is so ripe for speculative
manipulation that you might as well cover
the U.S. map with a bull’s-eye.
Credit
default swaps are not insurance. If you
buy fire insurance on your home, you
must own the house. If you buy credit
protection
on the United States, however, you do not need to own U.S. Treasury
bonds. If your protection gains value after you buy it—not
because the U.S. defaults, but because of market mood changes—you
can resell that protection and make a profit.
Lower credit risk
means a lower price for protection. Zero implies zero risk. The
higher the basis points, the higher the implied
risk. When U.S. credit default swaps were first introduced, the
price of protection was around two basis points. According to
Bloomberg, the price for five-year protection was around 38 basis
points (per annum) on Friday. But the price in the over-the-counter
market—where this stuff actually trades—was almost
double or around 75 basis points.
Since most traders in U.S. credit
default swaps don’t
think the U.S. will default any time soon, why are they trading
U.S. credit default swaps? They are speculating on price movements
the way a day trader buys and sells stocks to speculate on stock
price movements.
Volume in U.S. credit default swaps is relatively
small, but it can explode rapidly, just as volume expanded rapidly
for credit
default swaps on mortgage debt in 2006 and 2007.
Speculators Want
U.S. CDS Payoffs in Gold
Remember AIG? When prices moved against
AIG on its credit default swap contracts, AIG
owed cash (collateral)
to its trading partners.
AIG paid billions of dollars and owed billions more when U.S.
taxpayers bailed it out in September 2008.
U.S. credit default
swaps currently trade in euros. After all, if the U.S. defaults,
who will want payment in devalued U.S.
dollars? The euro recently weakened relative to the dollar, and
market participants are calling for contracts that require payment
in gold. If they get their way, speculators on the winning side
of a price move will demand collateral paid in gold.
The market
can create an unlimited number of these contracts very rapidly.
The U.S. wouldn’t have to ever default to
trigger a major disruption in the gold market. Spreads (or prices)
on the credit default swaps could simply move based on “news,” and
demand for gold would soar.
If this speculation drives up the
price of gold, and the available gold supply becomes limited,
are you willing to post your children
as collateral? I am pushing the point so that we put a stop to
this before it is too late.
Global Disaster in the Making
More than a year has passed since
former Treasury Secretary Henry Paulson went to Congress in September
2008 to plead for
special powers and TARP money to bail out U.S. financial institutions.
Yet there has been no meaningful financial reform.*
The European
Union has its own challenges. German Chancellor Angela Merkel
recently called
for limits on credit derivatives
on Greece, since the European Union is concerned about misuse
of credit derivatives for speculation. Chancellor Merkel did
not go far enough.
World leaders shouldn’t merely ask for
limits on sovereign credit derivatives. They should demand a
ban on all sovereign
credit default swaps.
*This video explains how cheap money, wide-spread
bad (often predatory) lending, phony securities, credit derivatives,
and
Wall Street banks’ massive over-borrowing led to our current
financial crisis. Yet there is still no meaningful reform. Explanation
of credit derivatives begins at 8:00.
Janet
Tavakoli is the president of Tavakoli
Structured Finance, a Chicago-based firm
that provides consulting to financial institutions
and institutional investors. Ms. Tavakoli
has more than 20 years
of experience in senior investment banking
positions, trading, structuring and marketing
structured financial products. She
is a former adjunct professor of derivatives
at the University of Chicago's Graduate
School of Business. She is the author of: Credit
Derivatives & Synthetic Structures (John
Wiley & Sons,
1998, 2001), Structured
Finance & Collateralized
Debt Obligations (John
Wiley & Sons, 2008).
Janet
Tavakoli's book on the global financial meltdown is Dear
Mr. Buffett: What An Investor
Learns 1,269 Miles From
Wall Street (Wiley 2009) Clients
of Tavakoli Structured Finance
have the benefit of proprietary consultation, which is
not available in any other paid or public forum. Clients
also commission proprietary research and analysis. TSF
makes some information available to the general public.Please
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