Derivatives, derivatives, derivatives!

Over and over again, we discover, upon some obscure audit or forensic accounting report being published, derivatives were the real culprit behind some bank/credit union/country failing.

Now we have Greece considering suing U.S. banks over credit default swaps on their sovereign debt and other derivatives.

Greece is considering taking legal action against U.S. investment banks that might have contributed to the country’s debt crisis, Prime Minister George Papandreou said.

“I wouldn’t rule out that this may be a recourse,” Papandreou said.

While this interview is making headlines buzz, to read the details of why Greece would consider suing U.S. banks click here and here

What a surprise, having a vehicle that pays out hansomely if a nation defaults on their debt might create some shady dealings. Bloomberg:

European Central Bank President Jean-Claude Trichet said May 6 that he was concerned about speculation in bond markets using credit default swaps. “By first buying the CDS and then trying to affect market sentiment by going short on the underlying bond, investors can make large profits,” he said.

Then we have a report, (h/t Gretchen Morgenson), detailing how credit default obligations (CDOs), caused the collapse of a credit union into failure. We've read this story over and over, from towns in Norway to Lehman Brothers.

Eastern Financial suffered substantial losses in the CDO investments during 2007 and 2008 that, coupled with increasing loan losses and other contributing operating factors, quickly eroded the credit union’s net worth and lead to its insolvency.

Eastern Financial purchased $94.8 million in CDOs from March 2007 to June 2007 funded by short term borrowings, which brought the total investments in CDOs to $149.2 million. Most of these CDOs deteriorated rapidly in value once purchased. Unrealized losses, eventually recognized through earnings as of September 30, 2007, were $63.4 million. By early 2009, twelve CDOs were completely written off for a $106 million loss the remaining CDOs had a $43.2 million book value with unrealized losses totaling $37.9 million. In the end, EFFCU essentially charged off all eighteen CDO investments, resulting in losses of $149.2 million between June 2007 and June 2009, when EFFCU was merged into Space Coast Credit Union by the NCUA.

Recall derivatives were the real screw job on the AIG bail out.

Yet in the Senate, derivatives reform is under siege.

Economist Joseph Stiglitz:

One provision holds particular promise -- and has the banks especially riled up. This is the idea that the government should not be responsible for the "counterparty risk" -- the risk that a derivatives contract not be fulfilled. It was AIG's inability to fulfill its obligations that led the U.S. government to step into the breach, to the tune of some $182 billion.

The modest proposal of the agriculture committee is that the U.S. government (the Federal Deposit Insurance Corporation) stop underwriting these risks. If banks wish to write derivatives, they would have to do so through a separate affiliate within the holding company. And if the bank made bad gambles, the taxpayer wouldn't have to pick up the tab.

This change would help fix the current system, where those who buy this so-called "insurance" enjoy the subsidy of the essential, free government guarantee; and where competition among the few issuers of these risky products is sufficiently weak that they enjoy high profits.

Here is a floor speech by Senator Byron Dorgan trying to do the obvious, ban naked credit default swaps and believe this or not, the Senate isn't even letting it come up for a floor vote. A naked credit default swap means anybody can bet against some asset or even a sovereign nation's failure and they don't have to own or be affiliated in anyway with the underlying asset they are betting on going under. Nice huh? A whole group of hedge funds can bet against a nation's debt. Voilà, because of that action, the interest rate and spread increase, making it harder to service that debt. One can rig a CDO, then bet against it with CDSes. Read not only bad math, bad computation too, to understand some of these derivatives, by the models themselves, lead to fraud, contagion and system risk.


Dorgan might have to fillibuster the Democratic Senate, to get his practical and obvious amendment even on the Senate floor for a vote. As Senator Dorgan says:

Shame on them!

Gets worse. There is a major loophole already in the Senate financial reform bill on derivatives. You guessed it, the loophole is around the end user exemptions:

Standard contracts and those not involving so-called "commercial end users" -- firms like Coca-Cola and General Electric that use derivatives as insurance against currency and interest-rate fluctuations, for example -- will be required to go through these clearinghouses.

The problem, however, is that there's apparently little consequence if firms evade the requirements, according to the email sent to a Banking Committee staffer by Americans for Financial Reform, an umbrella organization of consumer advocacy, public affairs and union groups arguing for reform. Some of these potential loopholes were first identified by Zach Carter of AlterNet.

"[T]here is no consequence for counterparties who enter into uncleared swaps even after a finding by the [Commodity Futures Trading Commission] or [Securities and Exchange Commission] that the swaps must be cleared," the email reads. The bill "does not prohibit the use of uncleared swaps and, even more egregious, expressly states that no swap can be voided for failure to clear."
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In other words, if parties to a swaps contract -- a type of derivative that involves regular payments over a specified time period -- do not trade via a clearinghouse when they're supposed to, there's no penalty, the group argues. Also, those swaps can't be deemed invalid because of this evasion.

Furthermore, the email points out, even though federal regulators may require that a swap be cleared, they can't mandate a clearinghouse to accept it.

Every day, the same story, different verse, a little big louder, a little bit worse, comes out on so many of these derivatives. How many financial meltdowns and potential sovereign collapses plus crushing debt does one need to take some action?

Repeatedly evidence has shown many of these derivatives are contributing to global sovereign collapses, putting nations into massive debt with a litany of bail outs which only buy time.

Shame on them!