Tavakoli Structured Finance LLC

The Financial Report

By Janet Tavakoli

President Obama Might Ask Who Benefits from U.S. Debt Default

Bloomberg News’ Yalman Onaran wrote an article on Monday about the disaster that would unfold if we don’t raise the debt ceiling and the U.S. has a technical default by missing an interest payment on U.S. Treasuries. James Kochan’s quote summed up my feelings: “Well, holy cripes!” It has never happened in modern history and would be a disaster greater than the September 2008 financial crisis.

China and Japan combined own $2.4 trillion in U.S. Treasuries, and they are understandably upset with the U.S. about the possibility of a technical default.

Most of the financial press has focused on how awful a technical default would be, and who is upset. But our leaders might ask a different question. Who are the reprobates that are cheering for the possibility of a technical default on the U.S.? Who stands to gain? Who might be happy to set off this financial bomb?

Citigroup “Very Profitably” Gamed Eurozone Sovereign Bonds 

Some people will play with sovereign debt just to put a few more dollars in their own pockets. On August 2, 2004, when it was the world’s largest financial services group, Citigroup sold €11 billion of eurozone government bonds in less than two minutes and 30 minutes later bought back €4 billion at lower prices to pocket a profit of €17 million ($23 million).

Citigroup memorialized how it could “very profitably” destabilize the market. A July 20, 2004 memo titled “Challenging the dominance of Eurex futures,” fell into the hands of the Financial Times. Päivi Munter reported that apparently Citigroup’s Simon Wiveil had to share this gem with his colleague Daniel Leadbetter about German sovereign bonds:  “When there is a liquidity imbalance . . . we drive up the Bund future [and] then hit out all the cash [bids] on MTS.”

Then CEO and Chairman Chuck Prince called the trades “knuckleheaded.” How could that be when people in the financial industry are so often called “the best and the brightest?”

Today, Citigroup’s 2004 manipulation of European sovereign debt seems quaint. In subsequent years Congressional testimony revealed massive fraud, suppression of bad loan data, violation of internal guidelines, persecution of whistleblowers, and reckless mismanagement at the very top levels of the bank.

According to the Congressional Oversight Panel that oversees the TARP program, Citigroup received $476.2 billion in cash and guarantees from U.S. taxpayers. Citigroup was the top recipient of U.S. aid. Bank of America was second with $336.1 billion, an enormous figure that was still $140 billion behind Citigroup.

To be clear I’m not saying that Citigroup is in any way interested in shenanigans in the U.S. debt market or credit derivatives markets. I am only reminding you that our financial system is prone to outrageous behavior and control fraud. Regulators, Congress, and the past and current presidential administrations have let criminals skate with little more than a wrist slap.

Credit Derivatives Linked to U.S. Debt Default

In 2010, I wrote a two-part commentary: “Washington Must Ban U.S. Credit Derivatives as Traders Demand Gold,” and “Credit Derivatives on United States: Games and Gold.” Who would buy protection against a default by the United States?

The answer is anyone who can profit from House Speaker John Boehner telling George Stephanopolous this at the end of Sunday morning’s nationally televised interview:

“The president — the president, his refusal to talk, is resulting in a possible default on our debt.” [Emphasis added]

House Speaker John Boeher, intentionally or otherwise, made someone a lot of money with that sound bite. The New York Times reported he has “tight ties” with lobbyists and former aides representing financial firms Goldman Sachs and Citigroup, among other industries.

Profits on Credit Derivatives on U.S. Debt: Shaken Confidence Is All That’s Required

If you buy protection using credit default swaps on U.S. debt, the United States doesn’t need to experience a technical default for you to make money. When people get nervous, the spread widens, increasing the value of the protection you bought. After Speaker Boehner’s remarks, anyone who bought protection had a gain—at least on paper.

Yesterday, spreads widened to around 60 bps. For the U.S. that’s very wide. It implies a default probability of over 5%. Let me provide some perspective. “AAA” rated corporate debt has a default probability of 0.00%. A default probability of 5% means corporate debt is non-investment grade or junk. Sovereign debt is judged by a variety of different metrics, but it’s clear that people are spooked.

If the U.S. actually experiences a technical default, it will be a huge windfall gain for anyone long credit default protection in the United States, in other words, “very profitable!”

How Large Is The Invisible Credit Default Swap Market on U.S. Debt?

Many pundits downplay the credit default swap market on U.S. debt on the grounds that the visible market of an estimated $8 billion appears very small relative to the total credit default swap market. (The size may be much larger today, given market jitters.) U.S. banks alone hold around $14 trillion in credit derivatives. But the size doesn’t have to be very large for someone to make a nice profit.

You can play all sorts of games with sovereign credit derivatives. For example, in 2001, a couple of hedge funds thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off. But J.P. Morgan told a different story 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 bought from Daehon.

Moreover, the size of the visible market is only an estimate, and the size of the invisible market is unknown. You may recall that the September 2008 market meltdown was due in a large part to credit derivatives and leverage. Most of those credit derivatives were invisibly embedded in other financial instruments.

You can invisibly embed credit default swaps on the U.S. into collateralized debt obligations (CDOs) and credit linked notes. You can also embed custom-made credit triggers into a variety of financial products. These triggers do not have to follow any sort of standard. You can make up hair triggers.

Credit default swaps on U.S. debt are normally contracted to payoff in euros, but you can write the contract to payoff in another sovereign currency or in gold. Gold is already allowed by derivatives exchanges to satisfy collateral calls on derivatives. Usually the payment in the event of default is based on the price of a treasury bond, but you can create binary credit default swaps that pay off 100% of the notional amount in the event of a technical default.

Follow the Money

My reason for writing the 2010 commentary was to encourage Congress to ban credit derivatives on U.S. debt due to the potential for abuse. Perhaps no one is abusing this situation for financial gain. But while we’re asking about the horrific consequences of not raising the debt ceiling—and possibly throwing the U.S. into a technical default—we should also ask who would benefit if this happened?

If you follow the money, you often find someone moving levers behind the scenes.

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