Weaponizing Credit Default Swaps

Another lovely investment strategy for tough times. From Friday’s Financial Times:

Speculators are being armed by banks to hurt Main St

By Mark Sunshine
Published: November 28 2008 02:00 | Last updated: November 28 2008 02:00

Warren Buffett called credit default swaps “financial weapons of mass destruction” and they are about to annihilate Main Street. In a disturbing new trend, international banks are creating syndicated credit facilities that “weaponise” credit default swaps (CDS) by using the trading price of a borrower’s CDS to set the interest rate paid by the borrower. Unfortunately, banks don’t understand that they are arming speculators to ambush and kill unsuspecting and otherwise healthy companies. Regulators are oblivious to this danger as are the victims.

CDS are unregulated derivative instruments that are essentially a bet on the creditworthiness of a company. CDS are traded in an unregulated, opaque over-the-counter market, where prices have questionable value and can be easily manipulated and misrepresented.

Recently, it was reported that banks have started tying commercial loan interest rates to the price of a borrower’s CDS. This seemingly innocuous loan provision allows speculators to bet that a borrower’s stock price will go down while insuring that the bet pays off by manipulating the borrower’s CDS prices upward.

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