Curbing Derivatives Might Hurt, Not Help, Greece

Derivatives have become a dirty word.

The complex financial products helped blow up the U.S. housing market. They all but sank AIG. Now European officials want to crack down on a derivative called a credit default swap. It's an insurance-like product that they say has worsened Europe's debt crisis and could bankrupt Greece.

Oil traders on the floor of the New York Mercantile Exchange, New York.
Oil traders on the floor of the New York Mercantile Exchange, New York.

Hold on, many experts say: Credit default swaps -- contracts that insure debt -- have actually prevented Greece's debacle from worsening. Without them, they say, investors would be less willing to buy Greece's debt. It would likely need a bailout to run its government and service its huge debt. That could threaten Europe's economic rebound.

"If we get to a point where we've had enough with credit default swaps, then I think Greece will have serious problems," said Darrell Duffie, a finance professor at Stanford University.

Sellers of credit default swaps agree to pay the buyers if the debt goes bad. With swaps, investors who lend to countries by buying their bonds can reduce their risk. Without them, Duffie and others say, Greece's borrowing costs would escalate because lenders would demand higher premiums.

That's not how Greece sees it.

It argues that traders of the swaps who bet against Greece's debt are raising its borrowing costs, making default more likely. It claims trading of swaps -- which is unregulated -- is racking up big profits for Wall Street banks and hedge funds at Greece's expense.

"Speculators are making billions every day betting on Greece's default," Prime Minister George Papandreou said this week in Washington, where his government is pressing the U.S. to restrict such trading.

Greece favors banning "naked" credit default swaps on a country's debt. In naked trades, the buyers of the swaps don't actually hold the underlying debt. Yet they can still profit or lose money on the bet.

Papandreou likened this practice to buying insurance on a neighbor's house and then burning it down to collect. Without naming names, he said some U.S. banks that were bailed out during the financial crisis are using naked swaps to make "a fortune out of Greece's misfortune."

Such speculation, he warned, could trigger a "domino effect" of higher borrowing costs for indebted countries around the world.

The prime minister said President Barack Obama, after a White House meeting Tuesday, offered a "very positive" response to European ideasfor restricting currency trading. He said the issue would be discussed at the next meeting of the Group of 20 summit of leading and emerging economies in June.

Shooting the Messenger?

The Federal Reserve is investigating how Goldman Sachs and other banks are using credit default swaps and other derivatives. The Securities and Exchange Commission is examining the issue, too.

The securities industry says that blaming the products for Greece's problems is akin to shooting the messenger. The price of the swaps reflects merely the perceived risk of buying Greece's debt, it says.

A year ago, credit-default swap investors had to pay $250,000 to insure $10 million of Greek debt, according to CMA Datavision. By last month, the cost surged to a record $420,000.

As of Tuesday, the rate had fallen to less than $300,000 after Greece announced a $6.5 billion austerity package. Still, that's about 10 times the cost of insuring $10 million of U.S. debt.

Analysts acknowledge that heavy buying of swaps can temporarily drive up a country's borrowing costs. Greece on Thursday raised $6.83 billion through a 10-year bond issue. It paid a hefty premium to buyers willing to take the risk.

Yet without credit default swaps, the country's borrowing costs "would be even higher," said Brian Yelvington, head of fixed-income strategy at Knight Libertas.

Unable to hedge their bets on Greece's debt, lenders would demand punishing premiums from Greece, and would themselves have to pay more to offset the risk of such loans, said Mikhail Foux, a credit strategist at Citigroup in New York.

"It would be destabilizing for everybody," Foux said. "As soon as you restrict the credit default swap market in even a small way, it will be more expensive to borrow and more expensive to hedge."

Foux and Yelvington say restricting naked swaps likely wouldn't make a difference for Greece. They say the amount invested in the swaps represents only a small fraction of Greece's outstanding debt.

Investors hold $406 billion worth of outstanding Greek bonds, according to Citigroup . But they hold only $9 billion in insurance against that debt through credit default swaps.

Credit default swaps on countries' bonds "represent only a small percentage of government bond trading volumes, so it is difficult to conclude (they're) dictating price levels," the International Swaps & Derivatives Association said in a statement.

U.S. regulators are trying to determine if that's indeed true. The Federal Reserve is using its supervisory authority over banks to examine swaps and other transactions that Goldman Sachs and other banks made with Greece.

Goldman was already under scrutiny for currency swap deals it undertook with Greece to reduce that country's debt. Goldman defended the transactions last month. It said their impact was minimal and within the rules.

The SEC has declined to say if it's investigating Goldman's derivatives dealings. The agency has said only that it's examining potential abuses and destabilizing effects of credit default swaps and other unregulated financial instruments.

Goldman declined to discuss the inquiries.

"As a matter of policy, we do not comment on regulatory matters," spokesman Ed Canaday said.

The probes are the latest setback for the elite Wall Street firm. It came under criticism for its use of derivatives contracts during the housing crisis in 2008. When the subprime-mortgage bubble burst, credit default swaps that insured against the default of mortgage-backed securities collapsed. That led to the downfall of Lehman Brothers. The same fate nearly befell insurance conglomerate American International Group.

AIG was saved only through a $182 billion taxpayer bailout. Much of the rescue money went to meet the company's obligations on credit default swaps. And Goldman was among the biggest recipients of the AIG money, at $12.9 billion.

The Obama administration is seeking new regulations on derivatives.

One bill in the House would force companies to conduct derivatives transactions on regulated exchanges, under the oversight of the SEC or the Commodity Futures Trading Commission. Companies would have to have enough money in hand to protect themselves against the transactions' risks.