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European Leaders Call for Crackdown on Derivatives

Goldman Sachs had a bright idea for its clients: buy credit-default swaps — those controversial instruments that helped trip up the American International Group — in case certain nations ran into financial trouble.

Luxembourgian Prime Minister Jean-Claude Juncker and German Chancellor Angela Merkel.
Jean-Christophe Vergaegen | AFP | Getty Images
Luxembourgian Prime Minister Jean-Claude Juncker and German Chancellor Angela Merkel.

That advice, contained in a confidential report prepared by the bank last August, turned out to be prescient. It arrived months before Greece and its staggering debts became the big story in the financial markets. The report, a copy of which was obtained by The New York Times, warned that the risks posed by spiraling government debts might be graver than people realized.

Now, some European leaders are pointing fingers at the very financial instruments that Goldman was recommending. They insist that credit-default swaps — and the traders who wield them — have worsened the problems in Greece and elsewhere. Calls are growing for the United States and Europe to crack down on speculative trading in general and on such swaps in particular.

On Tuesday, as the Greek prime minister, George A. Papandreou, met with President Obama in Washington, the German chancellor, Angela Merkel, added her voice to the chorus calling for closer scrutiny of derivatives. The president of the European Commission, José Manuel Barroso, also weighed in, saying his office would closely examine certain types of swaps trades that he called “purely speculative.”

“If needed, the commission will use the competition powers it has in that matter,” Mr. Barroso said, speaking at the European Parliament in Strasbourg.

But even among policy makers, the exact role of credit-default swaps — which essentially provide insurance in the event a company or government defaults on its debts — remains the subject of fierce debate. Germany’s financial services regulator, known as BaFin, said Tuesday that despite all the hand-wringing it had found no evidence that speculators were using swaps to bet aggressively against Greece. Instead, BaFin said, the evidence suggested that most investors were trying to use the instruments to hedge their risks, much the way farmers use futures to guard against a sudden plunge in crop prices.

But in a speech in New York, Gary Gensler, chairman of the Commodity Futures Trading Commission, singled out credit-default swaps as directly contributing to the financial crisis and needing comprehensive reform.

“The 2008 financial crisis had many chapters, but credit-default swaps played a lead role throughout the story,” he said. “We need broad regulatory reform of over-the-counter derivatives to best lower risk and promote transparency in the marketplace.” He said credit-default swaps had “unique features that require additional consideration.”

The criticism of credit-default swaps stems, in part, from the multiple and at times seemingly conflicted roles that investment banks like Goldman Sachs often play in the markets.

Over the last decade, Goldman and others helped the Greek government legally mask its debts so the nation appeared to comply with budget rules governing its membership in the euro, Europe’s common currency. In that role, Goldman advised Greece and, in return, collected hundreds of millions of dollars in fees from Athens.

But, just as the true extent of Greece debts began to worry investors, Goldman put on another hat. Last July, it sent clients a 48-page primer on credit-default swaps entitled “C.D.S. 101.” The report said that credit-default swaps enabled investors “to short credit easily” — that is, to bet against certain borrowers. The report made no mention of Greece.

Goldman followed up with its August report, issued by its hedge fund research unit, which said the price of swaps “may be too cheap as it may underestimate the risks to developed countries who have recently issued large amounts of debt.”

“Buy C.D.S. of developed sovereigns,” the report said. Again, no countries were singled out.

Despite such advice, Goldman promptly went back to work for the Greek government. Since last September, the bank played a role in underwriting more than $33 billion of new bonds for Greece, Spain and Britain, according to data compiled by Dealogic. Those three countries are among the most heavily indebted developed nations, as measured by their debts relative to economic output.

Goldman, in a statement, said its reports merely outlined a variety of trading strategies. The bank said it saw no conflicts in its various roles.

“It is not a conflict to sell new products on behalf of clients while suggesting to other clients, who may have different opinions and objectives, that they may want to buy insurance to protect themselves,” Goldman said.

Andrew Ang, a finance and economics professor at Columbia Business School, said banks typically tried to maximize their profits across a range of businesses, and that he saw no conflict in Goldman Sachs’s approach.

Still, others warn that credit-default swaps have evolved from what was essentially an insurance product into instruments of pure speculation.

Jack Ewing contributed reporting.

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