Opinion: Germans resist naked swaps

BOSTON — The “D” word — derivatives — achieved pariah status again this week on both sides of the Atlantic as governments continued their epic battles to rein in an unwieldy financial system.

In an effort to curb speculation, Germany’s Federal Financial Supervisory Authority banned the purchase of credit default swaps on government debt unless investors own the underlying bonds. The U.S. Senate Senate Thursday passed a sweeping financial reform bill that requires most derivatives to be traded on exchanges and prevents banks from trading them.

Even though it seemed like the world was on the road to recovery, the Greek debt crisis has reawakened old and painful memories of how much damage the 2008 financial collapse caused. With Greece, it feels like we are now doomed to relive the Lehman debacle in country form.

“The risk is that the European situation will spiral out of control, spread within Europe beyond Greece and push Europe back into recession, and further damage the U.S. and global economy and financial system,” Edwin M. Truman, a senior fellow at the Peterson Institute for International Economics, told the U.S. House Financial Services Committee on Thursday.

Twenty percent of U.S. exports go to Europe, and at the end of 2009, half the total foreign exposure of U.S. banks, or $1.5 trillion was in the European Union. “The world economy will not recover without a reasonably healthy European recovery,” Truman added.

Germany has pledged $31 billion, France $25 billion and other eurozone countries about 28 percent of the trillion-dollar bailout package for Greece. The International Monetary Fund (IMF) will provide the rest; the U.S. contributes about 17 percent to the IMF. The U.S. Federal Reserve has reopened foreign exchange swap lines to a number of foreign banks to maintain liquidity and prevent credit from freezing up like it did in 2008.

German Chancellor Angela Merkel banned “naked” credit default swaps on government debt (those that do not own any underlying bonds), from exacerbating a dire situation.

When an institution lends money to a country by investing in a bond, it can also buy a credit default swap from a separate party that insures the investment just in case the country cannot repay the loan. Credit default swaps help eliminate the risk.

The crazy part of credit default swaps is that an investor can purchase them without owning any of the underlying debt or asset. Naked swaps can lead to intense betting against companies or countries when they are in their weakest position. It can result in the same kind of speculative frenzy that many believe contributed to the final downfall of Bear Stearns and Lehman Brothers. Only this time, the speculation could hurt not just Greece, but all 16 countries that use the euro.

"If the euro fails, Europe fails,” Merkel told members of Germany’s parliament on Wednesday. “If we do not avert this danger, the consequences are incalculable.”

In the web of international capital markets, speculators on European debt can cause a chain reaction to U.S. markets, just as speculators against a U.S. company can ripple into the European banking system.

The International Swaps and Derivatives Association (ISDA), a group that represents participants in the privately negotiated derivatives industry, protested, in March, that naked credit default swaps are not “burning down the house.” But after Germany banned the naked sales this week, the ISDA softened its tone, writing in a news release that the organization “recognizes the concerns of national authorities in managing the volatility in their respective government debt markets.”

It’s hard to say with accuracy how large recent trading in naked credit default swaps on European sovereign debt has been, because that information is not public. It is not provided to the Depository Trust & Clearing Corporation (DTCC), according to a spokesman, which posts information about credit default swaps on its website. Only the regulators and the bankers know for sure. When trying to make derivatives more transparent, this would seem to be one area in need of vast improvement.

Government officials worldwide are grappling with how to rein in naked credit default swaps. In March, Gary Gensler, head of the U.S. Commodities Futures Trading Commission, suggested that judges restrict or limit “empty creditors,” purchasers of naked credit default swaps, from participating in bankruptcy proceedings.

The ISDA and other derivative organizations are in an intense race against regulation and are trying to make their business as transparent as possible. But the ISDA erred in their Big Bang protocol last year by not making CDS include restructuring for U.S. investors, while CDS contracts in Europe still include restructuring clauses. “That means the CDS prices in different countries still mean different things, which will hinder coordinated industry development of pricing models and applications,” said Joseph R. Mason, a finance professor at the Wharton School, in his appearance before the U.S. House Financial Services Subcommittee on Capital Markets.

It certainly seems like the rules regarding CDS should be written with international consistency to foster resolution between the investor and the country. Investors should take the first losses.

Based on estimates from Deutsche Bank, Greece’s sovereign debt could lead to as much as 75 billion euros of losses for European banks. Josef Ackermann, chief executive of Deutsche Bank, told German television ZDF this week that he doubted Greece would be able to repay its debt. Greece has not agreed yet to a voluntary restructuring.

Credit default swaps provide a very useful role in protecting investors and helping to free up capital that can in turn be invested elsewhere. The aim is to figure out how to make them less destructive, and more responsible, so that governments don’t have to continue bailing out companies, banks or other governments.

The U.S. Senate financial overhaul bill must now be reconciled with the House version approved in December, which could happen within the next month.

Governments would appear to have the upper hand in their struggle with the financial sector since they are, after all, the only entities with the power to bring the banking system and other countries back from the brink. As more politicians are turned out of office by voters who are tired of their timidity, it seems they are finally gaining the courage to exercise their authority.