A stake in failure

In our last piece ("Still no action by Congress on credit default swaps," Jan. 31), we explained that these contracts are essentially insurance in the financial markets. Properly regulated, they, like insurance, can serve a useful purpose. If controlled, they allow investors to manage risk and encourage them to fund worthwhile projects.

The standard insurance industry has learned the hard way that limits are essential to avoid abuse and perverse incentives introduced into the market. It's fairly simple, really. We cannot and do not allow people to use insurance to take a financial stake in failure. But a credit default swap (CDS) allows institutions to take a stake in failure with predictable results.

The problem with credit default swaps began with the Commodity Futures Modernization Act of 2000, which, ironically, was designed "to promote innovation for futures and derivatives and to reduce systemic risk by enhancing legal certainty in the markets for certain futures and derivatives transactions." The CFMA specifically exempts CDSs from regulatory oversight by the Securities and Exchange Commission, and pre-empts state laws regulating gambling, and laws against bucket shops (brokerage houses that only pretend to execute trades, outlawed in 1907).

Another crucial and tragic moment occurred in 2000 when the New York insurance commissioner and a former vice president at Goldman Sachs, Neil Levin, ruled that CDSs would not be regulated like insurance. Ironically, the company that asked for his ruling was AIG. Sadly, Levin cannot explain why he made that choice. He was killed in the World Trade Center on Sept. 11.

Federal Reserve chairman Alan Greenspan (who now works exclusively for John Paulson, who made $15 billion betting on failure in the housing market) and an assortment of other key players, many of whom came from Goldman Sachs, supported the CFMA.

Support for the CFMA was not universal. Brooksley Born, then chair of the Commodity Futures Trading Commission, prophetically warned that unrestricted derivatives trading would "threaten our regulated markets or, indeed, our economy, without any federal agency knowing about it."

Warren Buffet, who owns GEICO and knows something about insurance, also weighed in. He called complex derivatives, of which a CDS is one species, "weapons of mass financial destruction." Born and Buffet lost. So did the American people.

The damage done by CDSs in the secondary mortgage market was bad enough, but the cancer is spreading. It's called "basis packaging." Large hedge funds and private equity firms seek out companies with large, unsustainable debt and buy their bonds. This gives them a stake in the company but, more importantly, a vote in any decisions concerning bankruptcy. They then buy multiple CDSs that only pay off if bankruptcy follows. Whatever is lost in the bond investments is made back many times over when the multiple side bets pay off.

An August study for the Ministry of Finance in Canada concluded: "The relatively new CDS market is causing an increase in bankruptcy protection filings and bankruptcies, because the bond owners, who also own CDS contracts, need to have a credit event in order to trigger the CDS cash settlement. ... The incentive for advocating bankruptcy court filings is high from the bond owner who bought more CDS coverage than the amount of bonds owned, since he can make more money on the CDS contract cash settlement than he loses on the underlying bonds."

In just the past few weeks, and but for the threat of picketing by the Teamsters union of a Wall Street hedge fund and Goldman Sachs that would have almost certainly been the fate of the trucking firm YRC (the company combined from Yellow Freight and Roadway Trucking).

Michael Greenberger, a Maryland law professor and former head of trading and markets at the Commodity Futures Trading Commission, calls this a case of "Goldman et al seemingly forcing the country's biggest truck company into bankruptcy in order to get payoffs under CDS, with 50,000 jobs at stake."

David Einhorn, a hedge-fund entrepreneur who denounces these malign practices, claims that "basis packaging" has already been a major contributor to the bankruptcy of companies such as Abitibi-Bowater, General Growth Properties, Six Flags and even General Motors. Others include Nortel Networks as a victim of the practice. Jobs gone, pensions gone, lives ruined -- except for those placing side bets on failure.

If any major private employer in Southeast Missouri were a target of this practice, the issue would take on an urgency we would all feel.

We are hearing an echo of the corporate raiders of the 1980s: acquire companies through leveraged buyouts, purposefully taking on the very debt that spells a company's doom, and profiting when the company fails. And it's all legal.

Meanwhile, Congress sleeps and President Obama appoints more people from Goldman Sachs to key financial positions in his administration. Goldman Sachs was the largest private contributor to his campaign for the presidency. So it's no surprise that the new chairman of the Commodity Futures Trading Commission is from Goldman Sachs, as well as the new head of enforcement at the Securities and Exchange Commission. We have made John Dillinger a bank guard.

Free-market capitalism works well when capital is used to build businesses and create jobs. But by giving giant banks and hedge funds a stake in failure, credit default swaps are being used to destroy companies, employee pension funds and jobs.

The catch phrase of the moment in Washington is "jobs, jobs, jobs." Step one should be to control financial products whose perverted use destroys jobs. We repeat: "It's the credit default swaps, stupid."

Josh Bill is a former chief of staff to the late U.S. Rep. Bill Emerson, a former official in the Reagan administration and a former mayor of Sikeston.

Dr. Hamner Hill is the chairman of the Department of Political Science, Philosophy and Religion at Southeast Missouri State University.