Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

Credit Derivatives on United States: Games and Gold

In an earlier post, I wrote that Congress should act immediately to abolish credit default swaps on the United States, because these derivatives will foment distortions in global currencies and gold. Credit defaults swaps on the United States currently settle in euros, but there is talk of creating new contracts calling for settlement in gold. This is just a trial balloon discussion at the moment, but it is one that Congress should immediately deflate along with all credit derivatives on the United States.

Most traders in U.S. credit default swaps don’t think the U.S. will default as long as we have money printing presses, so they are speculating on price movements. If speculators manage to get contracts to settle in gold, speculators on the winning side of a price move will demand collateral paid in gold.

Gold is Collateral on the London CME

Presenting gold to satisfy demands for Performance Bond Collateral is already allowed on the London CME in a limited way since October 2009. [Hat tip to Hilary Till, co-founder of Premia Capital.] This is an excerpt from the announcement:

CME Clearing is introducing an enhancement to the existing Performance Bond Collateral schedule. Effective October 19, 2009, firms will be able to post physical gold to CME Clearing to cover non-segregated (NSEG) Performance Bond requirements. Initially, gold will be able to be posted to JPMorgan Chase Bank in London, England. In the near future, we hope to add additional depositories.

There will be a firm asset limit of $200 million. These guidelines are subject to change and will be evaluated on a regular basis.

Sovereign Credit Default Swap Contracts: Tower of Babble

The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.

J.P. Morgan’s posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

Regulators “Can’t Find” Evidence of Market Manipulation

European regulators said they saw no evidence of manipulation in the Greek credit default swap market, because they examined DTCC data. DTCC doesn’t capture all trades. Regulators wouldn’t have found evidence of the rampant manipulation in the U.S. mortgage backed securities market, either, since those trades were not captured on any clearing exchange. Moreover, already flawed “ISDA standard” documentation does not have to be used for opaque credit derivatives, including those that may reference sovereign debt. Allan Sloan at the Washington Post asked the right questions:

How much of this stuff do the Street people own? Where is it? What kind of securities has it been pushed into? No one knows. The one thing you can bet on, though, is that unraveling it all is going to be horribly complicated. Why? Because for Wall Street, complexity equals profitability.

I am not against covered short selling or puts, and some short sellers have done better work than main stream media in uncovering accounting manipulation and over-borrowing. (See David Einhorn’s early warnings about Lehman Brothers.) But the credit default swap market has a history of manipulation, and we are in the middle of a global financial crisis. Speculators can potentially destabilize a country or a company that’s already in trouble.

Time for Reform is Overdue

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.*

Lehman was not alone in fudging its accounting and over-borrowing. All of our legacy investment banks: Lehman Brothers, Goldman Sachs, Morgan Stanley, Bear Stearns, and Merrill Lynch had borrowed too much money, all of them used gimmicks to disguise debt, and all of them–including Goldman Sachs–would have gone under in 2008 without the bailouts.

World leaders should not be surprised that many countries also disguise debt and fudge their accounting. A good first step to reform of the financial system is to take away financial instruments that are ripe for abuse, starting with a ban on all sovereign credit default swaps.

Read finance articles by Janet Tavakoli.

Share This Post