Citibank continues experiments with derivatives

by Brian Johnson on March 1, 2010

cdsIn a recent Market Watch article, David Weidner commented that Citibank is attempting to create a new product, the CLX, which acts as insurance against financial collapse.  The product sounds, as Weidner deftly points out, a lot like the Credit Default Swaps that helped cause our current recession.  It involves the same risks and is being endorsed using the same shaky justifications.

The problem with financial products like the CDS or the CLX is, first and foremost, that it is unclear who covers the ‘bet.’ If financial collapse does happen, and Citibank is to make good on their CLXs, what guarantee is there that Citibank will be in a position, post-collapse, to honor its obligations?  And if it isn’t in a position to honor those obligations, who does?  What’s clear after the fallout of the CDS scandal is that the responsibility of paying off the debts of ‘too big to fail’ financial institutions inevitably falls on the American tax payer.

We understand the benefit afforded by these products to the economy.  A product that insures against collapse is attractive and useful, especially in an economy that is currently prone to collapse.  However, we have to also consider the problems that come  when these products are used as tools for financial speculation.  Credit Default Swaps work well for companies that want insurance against their collapse, but when you buy Credit Default Swaps to insure against the collapse of other companies, it becomes like buying life insurance on other people:  it is now in the best interest of the CDS owner for the other company to go under.  The product makes economic collapse more profitable than a healthy economy, and the damage caused is systemic.  The result, as we’re seeing now, is recession.

There are  two key ways to make these products safer.  First, all of these products should be traded on an open public exchange, which ensures that both parties have the money to cover their ‘bets’.  Secondly, these products should not be used for speculative purposes but only as vehicles for hedging legitimate business risks.

Citibank is trying to get backing for a financial product that sounds a little too much like the time bomb that blew up Wall Street in 2008.  Where are our politicians who are supposed to be protecting us from this kind of risk?  Why aren’t they bumping up regulation and taking banks to task? We own Citibank—shouldn’t our representatives on Capital Hill be in there telling them that this idea will not fly.  The problem with CDSs and products like them are problems that the politicians themselves created.  Ten years ago, these products were illegal (and obviously for good reason).  If politicians are going to allow them now, then they need to stop being intimidated by the banking industry, and put regulation into effect that will prevent further damage.  Their cowardice is allowing banks to continue practices that sent our country into this recession.

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