Credit Default Swaps Results in New Lawsuits From Pensions

All swaps are contractual agreements where each side pays the other on a certain set of circumstances.  Credit default swaps work similar to insurance, at least in theory.  In a simple example:

•    Party C owes Party A money
•    Party A makes regular, fixed payments to Party B
•    If Party C defaults on the debt it owes Party A, then Party B pays Party A back for the entire amount it lost.

What has happened is that Party A and Party B have changed who bears the risk of Party C’s ability to pay back its debt.  Party A is guaranteeing that it will get back less than it would without entering into the swap, even if Party C never defaults, because it is making regular payments to Party B.  However, in exchange for that loss, Party A knows how much it is going to get over time.  Whether Party A gets paid by Party B or Party C makes no difference, Party A gets paid either way.  Party B is choosing to take the chance that Party C will default, and Party B will be forced to pay out, in the belief that it is more likely that Party C will not default, and Party B just gets to pocket and keep the payments Party A was making. 

There are a number of reasons that various companies are willing to participate in these arrangements, but at its base, the goal of these transactions is to manage risk exposure.  As a result of this common goal, the credit-default market has grown to be over $25 trillion.  However, three Danish pension funds, as well as the investment company that apparently manages them, has filed suit in U.S. Federal Court alleging that various banks have violated U.S. anti-trust law in the credit-default market.  Specifically, the pensions are claiming that these banks are unlawfully restricting customer access to swap pricing and exchanges to trade the swaps.  As a result, they claim that the banks have maintained artificially inflated prices on these swaps, costing the swap holders billions of dollars. 

The banks named in the suit include:

•    Bank of America Corp.;
•    Barclays PLC;
•    BNP Paribas S.A.;
•    Citigroup Inc.;
•    Credit Suisse Group AG;
•    Deutsche Bank AG;
•    Goldman Sachs Group Inc.;
•    HSBC Holdings PLC;
•    J.P. Morgan Chase & Co.;
•    Morgan Stanley;
•    Royal Bank of Scotland Group PLC;
•    and UBS AG.

This suit comes on the heels of another almost identical claim filed by the Sheet Metal Workers pension plan filed in May 2013.  Similarly, the U.S. Justice Department stated starting in 2009 that it was investigating possible illegal, anti-competitive conduct in the credit-derivatives market, which investigation is still on-going.  The European Commission has similarly accused multiple banks of colluding to prevent credit-default swaps from becoming traded on open exchanges.

Aside from the lack of a free market to get fairer prices for parties that buy these products, credit-default swaps have caused a number of problems and losses for many investors.  These swaps are often sold as part of a package deal with other securities such as bonds, and explained by brokers as a way to protect the party entering into the swap.  However, many times these swaps do not protect the investor the way that they expected.
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