In the eye of the storm: the debt crisis in the European Union (5/7)

CDS and rating agencies: factor(ie)s of risk and destabilization

23 September 2011 by Eric Toussaint

In July-September 2011 the stock markets were again shaken at international level. The crisis has become deeper in the EU, particularly with respect to debts. The CADTM interviewed Eric Toussaint about various facets of this new stage in the crisis.

Part 5: CDS CDS
Credit Default Swaps
Credit Default Swaps are an insurance that a financial company may purchase to protect itself against non payments.
and rating agencies Rating agency
Rating agencies
Rating agencies, or credit-rating agencies, evaluate creditworthiness. This includes the creditworthiness of corporations, nonprofit organizations and governments, as well as ‘securitized assets’ – which are assets that are bundled together and sold, to investors, as security. Rating agencies assign a letter grade to each bond, which represents an opinion as to the likelihood that the organization will be able to repay both the principal and interest as they become due. Ratings are made on a descending scale: AAA is the highest, then AA, A, BBB, BB, B, etc. A rating of BB or below is considered a ‘junk bond’ because it is likely to default. Many factors go into the assignment of ratings, including the profitability of the organization and its total indebtedness. The three largest credit rating agencies are Moody’s, Standard & Poor’s and Fitch Ratings (FT).

Moody’s :
: factor(ie)s of risk and destabilization [1]

CADTM: You haven’t talked about Credit Default Swaps (CDSs) yet.

Eric Toussaint: CDSs are a derivative financial product which is not submitted to any form of public control. They were created in the first half of the 1990s in the middle of the era of deregulation. Credit Default Swap literally means permutation of unpaid debts. Normally, it should allow the holder of a loan to obtain compensation from the CDS seller in the case of default by the bond Bond A bond is a stake in a debt issued by a company or governmental body. The holder of the bond, the creditor, is entitled to interest and reimbursement of the principal. If the company is listed, the holder can also sell the bond on a stock-exchange. -issuer, whether a government or a private company. I use the conditional for two main reasons. Firstly, a CDS can be bought as protection against the risk of non repayment of a bond that the buyer does not have. This is the same as taking out insurance for the house next door, hoping that it will catch fire so that one can get the money. Secondly, CDS sellers do not begin by banking enough funds to indemnify victims of defaults. If a whole lot of private companies having issued bonds should go bankrupt, or if a major lender State should default on payments, it is quite certain that CDS sellers would be incapable of indemnifying as promised. In 2008, the collapse of the North-American company AIG, the biggest international insurance company (which was actually nationalized by Bush to avoid the consequences of bankruptcy) and that of Lehman Brothers were directly linked to the CDS market. AIG and Lehman had both been very active in this sector.

The CDS enables all sorts of manipulations. I had the opportunity to observe closely an attempt at manipulation when I was a member of the audit commission for the internal and external debts set up by the government of Ecuador in 2007, which delivered its report in September 2008. While we were auditing the Ecuadorian debt and President Rafael Correa was threatening to stop paying the illegitimate part of the debt to the international money markets, a private North-American company contacted the Ecuadorian government with a most edifying proposal. The company suggested that President Correa should let it be known that he was going to suspend payments just before the next due-date three weeks later. This would enable the company to sell CDSs for a value they had calculated at USD 300 million. The final outcome was supposed to be as follows: in reality, Ecuador would pay what it owed as usual. This would mean that the company would not need to indemnify the CDS holders and it would give half the proceeds to the Ecuadorian government. The company claimed that this operation was completely free of any risk of prosecution as it would be an over-the-counter transaction outside US government control. It claimed to have already carried out similar transactions on several occasions. In the end, the Ecuadorian government refused the offer, opting for another strategy which produced good results. The point about this true-life story is that it illustrates that issuers and buyers of CDSs can carry out all sorts of manipulations. Let us not forget that right up until the AIG disaster and the collapse of Lehman Brothers, the IMF IMF
International Monetary Fund
Along with the World Bank, the IMF was founded on the day the Bretton Woods Agreements were signed. Its first mission was to support the new system of standard exchange rates.

When the Bretton Wood fixed rates system came to an end in 1971, the main function of the IMF became that of being both policeman and fireman for global capital: it acts as policeman when it enforces its Structural Adjustment Policies and as fireman when it steps in to help out governments in risk of defaulting on debt repayments.

As for the World Bank, a weighted voting system operates: depending on the amount paid as contribution by each member state. 85% of the votes is required to modify the IMF Charter (which means that the USA with 17,68% % of the votes has a de facto veto on any change).

The institution is dominated by five countries: the United States (16,74%), Japan (6,23%), Germany (5,81%), France (4,29%) and the UK (4,29%).
The other 183 member countries are divided into groups led by one country. The most important one (6,57% of the votes) is led by Belgium. The least important group of countries (1,55% of the votes) is led by Gabon and brings together African countries.
, the US Federal Reserve FED
Federal Reserve
Officially, Federal Reserve System, is the United States’ central bank created in 1913 by the ’Federal Reserve Act’, also called the ’Owen-Glass Act’, after a series of banking crises, particularly the ’Bank Panic’ of 1907.

FED – decentralized central bank :
and the ECB ECB
European Central Bank
The European Central Bank is a European institution based in Frankfurt, founded in 1998, to which the countries of the Eurozone have transferred their monetary powers. Its official role is to ensure price stability by combating inflation within that Zone. Its three decision-making organs (the Executive Board, the Governing Council and the General Council) are composed of governors of the central banks of the member states and/or recognized specialists. According to its statutes, it is politically ‘independent’ but it is directly influenced by the world of finance.
repeatedly claimed that CDSs were a new product that offered excellent guarantees Guarantees Acts that provide a creditor with security in complement to the debtor’s commitment. A distinction is made between real guarantees (lien, pledge, mortgage, prior charge) and personal guarantees (surety, aval, letter of intent, independent guarantee). against risks (see the box on CDSs). Since then, their discourse has changed, but nothing, absolutely nothing, has been done to regulate the CDS market. Meanwhile, in view of the size of the phenomenon, CDSs constitute a huge time-bomb hanging over the international finance system. The fact is that CDS should be outlawed.

Monetary and financial authorities have encouraged the creation of a time-bomb composed of CDSs.

In 2007 when the crisis had already broken out in the USA and was spreading to the EU, Alan Greenspan, former Director of the US Federal Reserve, wrote: "A recent financial innovation of major importance has been the credit default swap. The CDS, as it is called, is a derivative that transfers the credit risk, usually of a debt instrument, to a third party, at a price. Being able to profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. from the loan transaction but transfer credit risk is a boon to banks and other financial intermediaries, which, in order to make an adequate rate of return on equity Equity The capital put into an enterprise by the shareholders. Not to be confused with ’hard capital’ or ’unsecured debt’. , have to heavily leverage Leverage This is the ratio between funds borrowed for investment and the personal funds or equity that backs them up. A company may have borrowed much more than its capitalized value, in which case it is said to be ’highly leveraged’. The more highly a company is leveraged, the higher the risk associated with lending to the company; but higher also are the possible profits that it may realise as compared with its own value. their balance Balance End of year statement of a company’s assets (what the company possesses) and liabilities (what it owes). In other words, the assets provide information about how the funds collected by the company have been used; and the liabilities, about the origins of those funds. sheets by accepting deposit obligations and/or incurring debt. Most of the time, such institutions lend money and prosper. But in periods of adversity, they typically run into bad-debt problems, which in the past had forced them to sharply curtail lending. This in turn undermined economic activity more generally.

A market vehicle for transferring risk away from these highly leveraged loan originators can be critical for economic stability, especially in a global environment. In response to this need, the CDS was invented and took the market by storm. The Bank for International Settlements Bank for International Settlements
The BIS is an international organization founded in 1930 charged with fostering international monetary and financial cooperation. It also acts as a bank for central banks. At present, 60 national central banks and the ECB are members.
tabulated a world-wide notional value of more than $20 trillion equivalent in credit default swaps in mid-2006, up from $6 trillion at the end of 2004. The buffering power of these instruments was vividly demonstrated between 1998 and 2001, when CDSs were used to spread the risk of $1 trillion in loans to rapidly expanding telecommunications networks. Though a large proportion of these ventures defaulted in the tech bust, not a single major lending institution ran into trouble as a consequence. The losses were ultimately borne by highly capitalized institutions—insurers, pension funds Pension Fund
Pension Funds
Pension funds: investment funds that manage capitalized retirement schemes, they are funded by the employees of one or several companies paying-into the scheme which, often, is also partially funded by the employers. The objective is to pay the pensions of the employees that take part in the scheme. They manage very big amounts of money that are usually invested on the stock markets or financial markets.
, and the like—that had been the major suppliers of the credit default protection. They were well able to absorb the hit. Thus there was no repetition of the cascading defaults of an earlier era.
" [2]

In 2007 the IMF issued the following declaration referring to the health of the United States and particularly CDSs, labelled new risk-transfer markets: “Although complacency would be misplaced, it would appear that innovation has supported financial system soundness. New risk transfer markets have facilitated the dispersion of credit risk from a core where moral hazard Moral hazard The effect on a creditor’s or an economic actor’s behaviour when they are covered against a given risk. They will be more likely to take risks. Thus, for example, rescuing banks without placing any conditions enhances their moral hazard.

An argument often used by opponents of debt-cancellation. It is based on the liberal theory which considers a situation where there is a borrower and a lender as a case of asymmetrical information. Only the borrower knows whether he really intends to repay the lender. By cancelling the debt today, there would be a risk that the same facility might be extended to other debtors in future, which would increase the reticence of creditors to commit capital. They would have no other solution than to demand a higher interest rate including a risk premium. Clearly the term “moral”, here, is applied only to the creditors and the debtors are automatically suspected of “amorality”. Yet it is easily demonstrated that this “moral hazard” is a direct result of the total liberty of capital flows. It is proportionate to the opening of financial markets, as this is what multiplies the potentiality of the market contracts that are supposed to increase the welfare of humankind but actually bring an increase in risky contracts. So financiers would like to multiply the opportunities to make money without risk in a society which, we are unceasingly told, is and has to be a high-risk society… A fine contradiction.
is concentrated to a periphery where market discipline is the chief restraint on risk-taking. (…)Although cycles of excess and panic have not disappeared — the subprime boom-bust being but the latest example — markets have shown that they can and do self-correct.
” (IMF, 2007 Consultations Report , article 4 with the United States) [3].

Clearly, certain supposedly reputable banks are still covering themselves against defaults through CDSs. Thus the Deutsche Bank announced at the end of July 2011 that it had reduced its exposure regarding the Italian debt by 88%. The principal German lender claims to have reduced its exposure in Italy from EUR 8 billion to EUR 997 million. According to the Financial Times, the Deutsche Bank achieved this not by selling over 7 billion euros’ worth of Italian bonds, but by a stroke of book-keeping wizardry, buying up CDSs to hedge its investments against possible default on the part of Italy. [4]

On another level, hedge funds Hedge funds Unlisted investment funds that exist for purposes of speculation and that seek high returns, make liberal use of derivatives, especially options, and frequently make use of leverage. The main hedge funds are independent of banks, although banks frequently have their own hedge funds. Hedge funds come under the category of shadow banking. , particularly active on the OTC OTC
Over-the-Counter market
An over-the-counter or off-exchange market is an unregulated market on which transactions are made directly between the seller and the purchaser, as opposed to a so-called organized or regulated market where there is a regulatory authority, such as a stock exchange.
and CDS markets, are worried at the perspective of the Greek debt being partly written off. They are wondering whether they will retain enough street cred to continue selling CDSs once they have failed to indemnify CDS holders of the Greek debt. [5]

CADTM: How much responsibility do rating agencies bear for the crisis?

Eric Toussaint: The North-American Standard & Poor’s and Moody’s and the Franco-American Fitch are the three private agencies which rule the roost regarding credit ratings and the credibility of bond issuers, whether they be State or corporate. [6] They have existed for almost a century but it was not until the 1970s-1980s, with the financialization of the economy, that their business took a sudden leap. However they are constantly in a situation of conflict of interests. Until the 1970s, it was the prospective buyers of bonds issued by the State and by companies who paid rating agencies for their advice on the quality of the issuers. Since then, the situation has been completely reversed: now it is the issuers of bonds who pay the agencies to rate them. What motivates the government and the companies is of course to get good ratings so that they can pay the lowest possible interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
to those who buy their bonds. Let us recall that until the eve of the collapse of Enron in 2001, highly paid rating agencies attributed top marks to the power supplier. Again, in 2008, it was the same story with the investment banks, Merril Lynch and Lehman Brothers. And again with Greece in 2009-early 2010. These are ample demonstrations of the harm they do. They should be sued for the damage caused by the results of the ratings they hand out. Risk assessment is a task which should only be entrusted to public bodies.

End of the fifth part

Translated by Christine Pagnoulle and Vicki Briault in collaboration with Judith Harris

Éric Toussaint, doctor in political sciences (University of Liège and University of Paris 8), president of CADTM Belgium, member of the president’s commission for auditing the debt in Ecuador (CAIC), member of the scientific council of ATTAC France, coauthor of “La Dette ou la Vie”, Aden-CADTM, 2011, contributor to ATTAC’s book “Le piège de la dette publique. Comment s’en sortir”, published by Les liens qui libèrent, Paris, 2011.


[1See the first part “Greece”, the second part “The great Greek bond bazaar” the third part “The ECB, ever loyal to private interests” and the fourth part “A European Brady deal: austerity for life

[2Alan Greenspan, The Age of Turbulence, Adventure in a New World, London, Penguin, 2007, pp. 371-2.

[3See For more on the IMF’s errors of judgement concerning the USA and Ireland, see: François Sana “Zéro de conduite pour le FMI

[4Financial Times, “Deutsche hedges Italian risk”, 27 July 2011, p. 13.

[5Financial Times, “Greek rescue plan worries hedge funds”, supplement FTfm, 8 August 2011.

[6There are others, such as the Chinese Dagong, but they have little influence.
Eric Toussaint

is a historian and political scientist who completed his Ph.D. at the universities of Paris VIII and Liège, is the spokesperson of the CADTM International, and sits on the Scientific Council of ATTAC France.
He is the author of Bankocracy (2015); The Life and Crimes of an Exemplary Man (2014); Glance in the Rear View Mirror. Neoliberal Ideology From its Origins to the Present, Haymarket books, Chicago, 2012 (see here), etc.
See his bibliography:
He co-authored World debt figures 2015 with Pierre Gottiniaux, Daniel Munevar and Antonio Sanabria (2015); and with Damien Millet Debt, the IMF, and the World Bank: Sixty Questions, Sixty Answers, Monthly Review Books, New York, 2010. Since the 4th April 2015 he is the scientific coordinator of the Greek Truth Commission on Public Debt.

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