Worry over new credit default swaps

U.S. bonds.

TEXT OF STORY

Tess Vigeland: The deal at the heart of today's Goldman hearings had to do with those credit default swaps we've all come to know and love over the last couple of years. OK -- maybe know, not love. The swaps are a form of insurance when you buy a bond. If borrowers don't make their payments, the insurance covers your loss. Most credit default swaps were designed for corporate and mortgage bonds. But now, they're being sold on muni-bonds, to investors who think state and local governments are about to go the way of the housing market.

Brett Neely reports.


Brett Neely: Most investors buy municipal bonds because they believe they're safe. But the recession has driven many state and local governments into deep financial trouble. Some, like California, are potentially in danger of going bust. Some investors want to protect against that happening; others want to profit from it. Banks are helping them by selling derivatives called credit default swaps.

MICHAEL GREENBERGER: It's purely a casino.

Michael Greenberger is a former derivatives regulator. He now teaches law at the University of Maryland.

GREENBERGER: A lot of this is one side betting that California will survive and another side betting that California will fail.

California's treasurer is complaining about these derivatives. He's worried if enough people buy them, it could spook investors and increase the state's borrowing cost.

Michael Greenberger describes how that could happen.

GREENBERGER: It's sort of a piling on, it becomes a whole group of people who want to see the worst happen to the municipality.

And it's not just California.

Banks sell these derivatives on debt issued by at least a dozen other states and municipalities.

Michael Schozer used to run the Assured Guaranty Corporation -- a derivatives specialist. He says credit default swaps get a bad rap. He says they can help states like California because they provide liquidity. That's the ability to buy and sell something easily.

MICHAEL SCHOZER: More liquidity generally means better pricing. Less liquid bonds trade worse than more liquid bonds. That's just a fact of life. So the derivatives actually will facilitate liquidity.

Schozer concedes that some investors may want to bet that California will fail. And that can make life very uncomfortable for the state treasurer.

SCHOZER: Your job is to get California the lowest borrowing costs possible. So if you're selling bonds, you're going to be out there saying what a great issuer you are, so that people will charge less interest.

Not easy if thousands of speculators are betting against you. Schozer and Greenberger both agree that there isn't much of a market yet for credit default swaps in cities and states.

SCHOZER: It's teeny.

For Schozer, that means there doesn't need to be much scrutiny. For Greenberger, that's a good reason to shut down the market before it becomes a big problem.

I'm Brett Neely for Marketplace.

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