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Controversies over credit default swaps are here again

November 23, 2011 |  8:03 am

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Remember credit default swaps, those complex financial instruments that took a good part of the blame for the last financial crisis?

Well, they're baaack. Now as subjects of controversy in the European financial crisis.

Indeed, despite Warren Buffett calling them and other derivatives "financial weapons of mass destruction," credit default swaps are again being used by financial players to take out big bets on the economic destruction of Greece and other struggling European countries (investors have taken out the largest bets against French and Italian bonds).

Just as a reminder, when investors buy credit default swaps, they are essentially buying an insurance policy that pays out if a particular bond defaults.

During the last financial crisis, some hedge fund magnates made billions by purchasing credit default swaps on subprime mortgage bonds. The people on the other side of those swaps had to pay out when homeowners stopped paying off their mortgages and the bonds defaulted.

This time around, investors have bought swaps on Greek and French sovereign debt, hoping the swaps will make them billions when Greece eventually defaults.

The problem is that it is not entirely clear what constitutes default in the case of a country like Greece, and the definition can change overnight, which isn't fun if you just spent $100 million buying them.

In fact, it turns out that the people who decide what constitutes default are an industry board made up largely of the same banks that sell the credit default swaps -- firms like Goldman Sachs and JPMorgan Chase & Co. This board recently decided that if Greece forces its bond holders to take a so-called "haircut" on Greek bonds -- a deal that will lower the value of Greek bonds -- it will not be considered a default and the people who bought the swaps will not get paid.

Jason DeSena Trennert, a founder of Strategas Research Partners, is one of many people who have cried foul, saying that the system exposes the degree to which the big banks get to write the rules of the financial game, and then change those rules when they might get hurt. In a new note to clients, he uses a school-yard analogy to make his point:

Yesterday Johnny insisted that the ball that bounced off of Dominic’s book bag was a goal. Today, on defense, he swears that it hit the post. One might think that after 20 years of education and socialization, Johnny, now a Managing Director in structured products at FancyPants & Co. and living in a co-op off Park Avenue, might have developed a greater sense of fair play. Sadly, as we are finding out in the post-financial modernization world, he has not.

Others, though, have not been so unhappy about the current argument over Greek credit default swaps. For one thing, some industry watchers say, this latest controversy may lead to the end of the market. Feilx Salmon, at Reuters, writes that investors who bought credit default swaps on Greece are going to be left high and dry, and will be unlikely to buy again:

If they hedged themselves in the CDS market, too bad. Whatever they paid for their CDS protection — and if they bought it recently, it could be quite a lot of money — will not help them one bit. If buying CDS doesn’t help you in the event of a default, then there’s really no point in buying CDS.

As during the last financial crisis, though, this may not be the end of the story. The problem with complex financial instruments is that it is not always clear what kind of havoc they can wreak until crisis hits.

RELATED:

How a credit default swap deal works

California Bonds | Betting against California

More moves afoot to rein in credit default swaps

-- Nathaniel Popper

twitter.com/nathanielpopper

Photo: Demonstrators clash with riot police in front of the Greek Parliament on June 29. Millions of Greeks participated in the strike to oppose new heavy austerity measures. Credit: Orestis Panagiotou / Ana-MPA

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