Goldman Recommends Credit Default Swaps Against NJ, CA, WI, FL, OH, MI, Others

[RedEarth]

Inquiring minds are now reading that Goldman Draws Ire for Advising Default Swaps Against New Jersey.

Goldman Sachs Group Inc., one of the top five U.S. municipal bond underwriters, is angering politicians and public-finance officials in New Jersey, Wisconsin, California and Florida by recommending that investors purchase credit-default swaps to bet against 11 states’ debt.

Bets against public debt, once unheard of on bonds considered safe enough for retirees, have soared as the National Conference of State Legislatures projects recession-fueled budget crises will cause $97 billion of shortfalls nationwide over the next 18 to 24 months.

It’s “disturbing” to advise investors to bet against the financial health of a state whose bonds Goldman helps sell, Assemblyman Gary S. Schaer, a Democrat who chairs the Financial Institutions and Insurance Committee, said last week in a letter to Chief Executive Officer Lloyd C. Blankfein.

‘A New Reality’

“Shorting municipal bonds -- the world is a new place,” said Patrick Born, chief financial officer for the city of Minneapolis. “There’s a new reality, at least for a while.”

The spread on 10-year California swaps widened to 289 basis points yesterday from 93 basis points in mid-September, according to data compiled by Bloomberg. Investors who sold their contracts could have pocketed $196,000. A basis point is equivalent to 0.01 percentage point.

New York-based Morgan Stanley has also recommended using swaps to bet against state credit. While Merrill Lynch recommends the derivatives to “institutions who want a vehicle to express relative value views,” Phil Fischer, a vice president of municipal strategy at the firm, said many are “thinly traded.”

As part of a September presentation to institutional investors on “Best Long and Short Risk Strategies,” Goldman recommended buying credit-default swaps on “a basket of liquid State General Obligation credits with current and worsening fiscal outlooks,” including California, Florida, Nevada, Ohio, Wisconsin and Michigan.

The firm also recommended the derivatives on states with “significant unfunded pension” and other retiree obligations, including Illinois, Connecticut, Hawaii, New Jersey, Massachusetts and Nevada.

The practice of betting against such states is “distasteful,” said Frank Hoadley, Wisconsin’s director of capital finance in Madison.
List of States Affected

New Jersey
California
Florida
Nevada
Ohio
Wisconsin
Michigan
Illinois
Massachusetts
Connecticut
Hawaii

There is probably another dozen or two states waiting in the wings. Expect to see municipal bond yields rise. And states are going to have to cut services, raise taxes, or both. That means more job losses, more foreclosures, and more bankruptcies, all deflationary phenomena.

http://globaleconomicanalysis.blogspot.com/2008/12/goldman-recommends-credit-default-swaps.html

[DJ13]

1. I think betting against our own government should be considered Treason

[autorank]

10. And that's the government that bailed their asses out of trouble.

These people are simply awful.

[hobbit709]

2. They only way to shut these greedy pigs up

is to string them up in front of their "institutions" and leave them dangling as an object lesson.

[Jackpine Radical]

3. Most of the states on the list are pretty blue.

Anybody else notice that?

[HereSince1628]

5. Yes, see below

I think they all went for Obama.

Which may not mean GS is waging war on Blue states, but might explain why the R's didn't get traction in states that were well into recession at the time of the election.

[HereSince1628]

4. And which of those states went for McCain????????????

Hmmm. Spurious correlation?

[mrreowwr_kittty]

6. Treason. Pure and simple. This should be illegal and a hanging offense. nt

[HamdenRice]

7. Worst part is that the issuers will sell short the bonds to hedge

Since cds issuers don't accumulate reserves, the only way for them to protect themselves against exposure to paying off as insurers is dynamic hedging -- a polite term for selling short on the reference security.

That means that the very act of issuing a cds insurance against default makes the default more likely to happen.

This practice should be banned immediately.

[anigbrowl]

15. At the very least, it creates a huge conflict of interest

I fail to see how an institution, even a large diversified one like GS, can possibly act as underwriter and adviser on the security (though at least you can't accuse them of talking it up to increase their issue profitability...um...).

[madrchsod]

8. good thing obama has his triage teams in place

cause this patient is slipping fast.....how many more days till the adults are in charge of the asylum?

[Joanne98]

9. I hate Goldman! Traitorous bastards!

[Festivito]

11. So, future bonds will be higher rates?

As they bet against us paying back our current bonds.

The real problems is that bunches of those fake money credit swaps and such are in our retirement system and the money has gone to the Caymans and elsewhere creating a problem in paying retirees as time passes. Me thinks.

[Jim Lane]

12. Criticizing Goldman is "kill the messenger" thinking

Many state governments are in financial difficulty. That causes investors to want to short their paper. It's not the other way around (i.e., the CDS's do NOT cause the financial difficulty).

You wouldn't try to "solve" the problem of global warming by banning thermometers.

The one legitimate issue I see here is that Goldman Sachs is also helping to sell some of the underlying securities involved. That puts Goldman in a conflict-of-interest situation. Apparently, some of Goldman's clients are being told that these securities are safe, while other clients are being told that the securities may well default. One group of clients (we don't know which one) is being given advice that doesn't reflect the firm's actual opinion. The firm is apparently deceiving some of its clients in the interests of collecting fees by selling them either state bonds or CDS's. Whichever side of the bet turns out to be wrong, the Goldman clients who lose money might have a pretty good lawsuit against the firm.

[Bushfire]

13. Don't you think the SEC could put a stop to CDS's?

They don't serve much purpose in the investment community, except another wager on a sports team to make a gambling reference. We should lobby our representatives in Congress to pass immediate legislation to put an end into speculative investment instruments that do not help employers invest in capitalization that can create jobs like stocks and bonds were intended to do.

[Jim Lane]

14. They have some legitimate uses.

They can be used so as to decrease risk, by spreading it around, rather than increasing it.

If the SEC can fine-tune regulations that allow some uses but prohibit abuses, that would be best. It might be impossible to write a loophole-free reg, though. In that case I'd agree with your suggestion of a flat prohibition.

[anigbrowl]

16. In principle, no. After all, you could argue that fire insurance is a bet on your house burning down

We all know the joke/plot device about the guy burning down his home/business to collect the insurance. Arguably, whenever you sell a fire insurance policy you're creating moral hazard by supplying a motive for someone to leave the insurance company holding the bag (and I bet we'll see more such cases in th year to come, where the market value of a property falls below the amount its insured for as well as the remaining equity, at which point it becomes 'rational' to burn it down and use the insurance money to pay off the mortgage).

[anigbrowl]

17. I meant to add that a CDS, like insurance, has legitimate ends

'Hedging your bets' is such a sensible thing to do that it's a phrase everyone understands, and that's what a CDS is for. Unfortunately, our fiscal system seems to have been overrun by out-of-control landscape gardeners.

[truedelphi]

18. But here's aproblem you might be able to explain - why is it that CDS's are even allowed to exist??

They came about as a way to allow for the insuring or guarantee of an investment. (At least that is my understanding.) So they are insurance, right? Yet the insurance regulating agencies don't regulate them, and why? Because they have a different name than insurance?

How is it that the financial industry can get away with stuff and nonsense like this? You or I cannot produce a medical device, call it a novelty item and sell it because I do not want the hassles that come about with dealing with the FDA. SO hw is that these instruments are allwoed to exist?