An EU probe announced today accuses the world's largest investment banks of collusion in setting the market for Credit-Default Swaps on Corporate and Sovereign debt. Are the by Bill Gee
(centrist)
Friday, April 29, 2011
An EU Antitrust probe into Credit Default Swaps (CDS) named Goldman Sachs, JP Morgan, and at least twelve of the other largest international banking organizations of possible collusion in the setting of market prices. For those of you who might have forgotten, a CDS is the same thing as a “Short” on a stock, in that those who purchase a CDS is betting on the failure of the bond rather than its success. Even more sinister than a CDS, is a CDSs, where the investor is betting against sovereign debt bonds – meaning they are betting against the economies of entire nations.
In order to understand what these banks are being accused of doing and its implications for you and I, we have to first understand how the market prices these types of securities in the first place.
When a company like Goldman Sachs has created a CDS for the purpose of selling it on the open market to investors, they need to provide data to an outside vendor who then evaluates the data and then provides a ballpark figure as to what they believe should be the market value. For example, if Goldman wants to put a new Corporate Bond onto the market, they would provide data to Standard & Poor’s, Finch, Moody’s, and about a dozen other vendors who would then provide them with a detailed analysis, a rating, and an estimate as to its market value. Then the bond ends up on the market and then the price goes wherever the market takes it. Unfortunately, there aren’t too many vendors out there who have a lot of expertise in rating CDS securities.
According to the EU probe, Goldman and over a dozen of the largest banks in the world have been funneling their CDS market data through a single firm, ICE Clear Europe. If the allegations prove to be true, what it would mean is that the world’s largest Investment banks are essentially sharing detailed information on their products prior to introducing to the market, which is a clear violation of the spirit of antitrust regulations.
What this means to you
So what? So what if the world’s largest banks are colluding to set market prices on their crappy products? The significance of this situation isn’t on the “how” but the “what”.
Remember, that a CDS is a bet AGAINST the economic fortunes of either a corporation or an entire government. As I have described in a previous article, if a foreign government’s bonds fail, it is likely to cause a chain reaction that will collapse the economies of an entire region, if not the economy of the entire world. So the chances of the Swap actually paying out are pretty slim save for another massive bailout, this time from another government like China, which is very unlikely. Unfortunately, there are investors out there who want to hedge their portfolios with CDSs securities not realizing that such a bet is likely to be counterproductive and overpriced. If CDSs securities were truly competitive, their market values would be quite low.
Investment banks make most of their money on mark-ups and fees. They know how impossibly ridiculous a CDSs is likely to be, but they still want to make a profit from the transaction because they know that demand exists or it. To do this, they need to collude with other investment banks in order to set the market rate for these securities and if the probe turns out to be true, they did so through ICE Clear. By increasing the market value, they create an environment where the CDSs is overpriced. By increasing the price, the market assumes there is a greater market for the product than actually exists, so they end up buying more of them. To meet the new demand, more CDSs securities are created and the next thing we know we have another economic A-Bomb ready to blow the world economy to kingdom come!
So what happens if the probe is proven and the banks are guilty? Well, not much. Each bank would have to pay a small fine in exchange for a statement that they did nothing wrong and that they were actually the victims in this situation. If the EU decides to come down hard, the banks will lock up the investigation in endless appeals and legal motions and in the meantime, they will find a new way to collude and corner the markets in their favor.
All of the new Financial Reform legislation out of Congress and the EU has done little to nothing to change this dynamic, largely because the politicians themselves are the bank’s biggest benefactors.
It is yet another example of how the banking industry has created its own “shadow government” where increasingly weaker regulatory bodies are unable to prevent or investigate the banks doing whatever they want. They can create markets from whole cloth, price it any way they like, and then convince the government and every taxpayer to foot the bill should their products fail.
Did you like this article? If you did, Thumb It! 2
thumbs so far
The views expressed
in this article are those of Bill Gee only and
do not represent the views of Nolan Chart, LLC or its affiliates.
Bill Gee is solely responsible for the contents
of this article and is not an employee or otherwise affiliated
with Nolan Chart, LLC in his/her role as a columnist.
