Remember those Credit Default Swaps (or CDS) that you kept hearing about in the news during the housing crisis? Well, they still exist, and are a large part of European Sovereign Debt Crisis in 2011. Let’s first define Credit Default Swap and put some perspective on this.
A CDS is a form of insurance on an investment. Let’s take a real example. A bank sells a bundle of home mortgages to Goldman Sachs. Then for a fraction of the cost of buying the mortgages, Goldman Sachs buys insurance against default of these mortgage bundles. Goldman is able to get a great rate on the CDS because the mortgage bundles are rated AAA. Goldman pays the rating agency millions to rate these bonds, and if they don’t get a good rating they can take their business elsewhere. Therefore, a rating agency like Standard and Poors gives them a AAA rating. So the end result is we have a CDS against a mortgage bundle with a AAA rating.
Next, Goldman starts selling the mortgage bundles to investors, but they keep the insurance on their default. They already know that these mortgages were not deserving of the AAA rating, but they are able to sell them that way.
Now we have almost the exact same thing happening in Europe. Goldman gave loans to Greek and other European banks, and also purchased insurance against them. In the case of Greece, they made a deal to receive revenue from airports and other state revenues in exchange for the loan. This allowed Greece’s balance sheet to appear sound enough for them to enter the EU several years ago.
And of course now we have firms like Goldman holding mostly the CDSs on the debt, and at the same time we see the rating agency downgrading their debt, increasing the likelihood of default, almost like a self fulfilling prophecy. Clearly the relationship of Goldman and the rating agency is one of mutual benefit at the expense of normal investors and the countries for which they are playing the financial games, which is now spreading to the rest of the World, just like the housing crisis.
Best Wishes to All!