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New Report: "Banking on Failure"

A new Public Citizen report released today titled “Banking on Failure” explores speculators’ use of credit default swaps (CDS) to bet on others’ misfortune. Drawing on research from Levy Institute scholars Marshall Auerback and L. Randall Wray, “Banking on Failure” considers the unseemliness and the grave dangers that these so-called financial innovations pose to our financial system.

Flickr by SEIU International

CDS are similar to insurance for lenders against the possibility that borrowers will default on loans. A bondholder who seeks to insure against loss typically contracts with an investment bank, whereby the bondholder makes periodic premium payments in exchange for the bank’s guarantee to repay the bondholder in the event of default.

But CDS don’t function like true insurance. They allow CDS buyers to insure more than the amount that they lend. In fact, they don’t have to lend at all to buy CDS protection. This is like buying fire insurance on another person’s house. There is no risk of loss to the buyer if the house catches fire — and there’s actually an incentive to torch it.

We are witnessing the dangers that CDS can create in Europe. Greece is experiencing financial distress due to mounting government debt.  In an attempt to mitigate potentially widespread financial damage that would be caused by Greece defaulting on its debt and the CDS payments that would follow, European government leaders are negotiating a restructuring agreement. Greece’s creditors would receive a 50 percent reduction in their interests and austerity measures would be imposed on the country. The European leaders’ hope is that the agreement will put Greece back on track to solvency without causing an all-out default, so CDS payments are not triggered.

But financial speculators’ may not be cheering for Greece to restructure its debts amicably. Because speculators who hold CDS may stand to profit from Greece suffering an all-out default, their interest may be that such a default occurs.

Goldman Sachs may be one such actor. In the past decade, Goldman Sachs sold Greece billions of dollars in financial products that helped mask Greece’s unsustainable debt. After becoming intimately involved in Greece’s financial affairs, it is possible that Goldman holds a considerable amount of credit default swaps. And now, because Goldman sits on the committee that could determine whether Greece’s CDS payments are triggered, the banking giant may ultimately decide to give itself a windfall.

Unfortunately, because the CDS market is unregulated and opaque, we can only speculate about Goldman’s holdings and motivations. It does not look good.