CT Blue

I have a soft spot (or is it a hard spot) in my heart for credit default swaps, since I actually tumbled to the threat they posed before the economic collapse they helped cause. Still, the damage they can do, and continue to do, continues to amaze me, as does the tepid response of governments world wide to the problem the pose.

Now it turns out that the Greek economic crisis is being exacerbated, if it was not caused, by these instruments.

Echoing the kind of trades that nearly toppled the American International Group, the increasingly popular insurance against the risk of a Greek default is making it harder for Athens to raise the money it needs to pay its bills, according to traders and money managers.

These contracts, known as credit-default swaps, effectively let banks and hedge funds wager on the financial equivalent of a four-alarm fire: a default by a company or, in the case of Greece, an entire country. If Greece reneges on its debts, traders who own these swaps stand to profit.

“It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich.

I’ll say it again. That’s why they don’t let me buy insurance on my neighbor’s house, yet for some reason the governments of the world stand passively by while “investors” buy insurance on their neighbor’s debt. But it’s actually much worse than simply having an incentive to start a fire, because in this case the speculators involved have the means to start the fire, in a perfectly legal manner, and the ability to pour gasoline on it once they get it going.

Need you ask who’s holding those matches?

As Greece’s financial condition has worsened, undermining the euro, the role of Goldman Sachs and other major banks in masking the true extent of the country’s problems has drawn criticism from European leaders. But even before that issue became apparent, a little-known company backed by Goldman, JP Morgan Chase and about a dozen other banks had created an index that enabled market players to bet on whether Greece and other European nations would go bust.

I’m not normally into conspiracy type thinking, but Goldman’s name sure does pop up a lot, doesn’t it?

The frustrating thing about this sort of thing is that the solution is fairly obvious. These kinds of contracts can exist only because they can be enforced. That means they ultimately rely on functioning legal systems. If those systems withdrew their support, they would die. In other words, they can be made illegal. It’s not possible to create a black market in these things.

Credit default swaps serve no useful purpose. They create nothing; though they seem to be good at destruction. They create a positive incentive for “investors” to destroy failing companies (such as GM, whose bailout was opposed by swap holders) and countries, such as Greece. To add insult to injury, when they bring down one of the players, such as with AIG, the government steps in to make the “investors” whole.

The question is whether this beast can be killed by the action of any single government (assuming the will). We are increasingly faced with a world in which these people are subject to no law because they reside in no nation. If they can’t swap here, they will swap there, though when disaster hits, it will cause problems everywhere. But I suppose that this is an academic question only; our government certainly lacks the will to contain these things. It’s actually a rare example of bi-partisanship. Everyone, from Obama on down, Republican and Democrat, prefers to take a pass on dealing with these and other exotic financial instruments, because the people who create them are shoveling lots of those old fashioned financial instruments called “dollars” into their campaign coffers.