Tavakoli: Credit Default Swaps on Sovereign Debt

As investigations unfold on questionable activity conducted by investment banks during the recent Greek debt crisis, certain financial instruments – similar to those that tanked the housing market – are coming under scrutiny for driving up sovereign bond prices through speculation. Janet Tavakoli has written extensively on these instruments and their potential dangers especially when used to insure underlying debt not owned by the purchasing party (or “naked trading” as it’s called in the financial world). In a recent entry on her Huffington Post blog, Ms. Tavakoli argues that the same speculative practices that wreaked havoc in a number of EU states are now occurring with United States Treasury bonds:

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…

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.

The parallels to this and what happened with AIG during the mortgage crisis are especially worth noting, writes Tavakoli:

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.

Over the past decade certain financial instruments have been misused to profit a select few at the expense of the many. It is imperative that our leaders in Washington take the necessary steps to ensure that our financial system exists to create opportunity – and not gamble against it.