International momentum is building for stricter oversight of derivatives trading, as a top U.S. regulator recommended new limits on credit-default swaps and European leaders pushed for a ban on speculative bets against government debt following recent financial turmoil in Greece. ...
German Chancellor Angela Merkel said Tuesday that her government is backing an initiative to curb the credit-default swaps market, together with France, Greece and Luxembourg, and she suggested Europe would forge ahead on its own even if the U.S. didn't go along.
José Manuel Barroso, president of the European Commission, the European Union's executive arm, said the commission would examine closely the possibility of banning outright "purely speculative" trading of the swaps. ...
As financial problems mounted for Greece and other euro-zone countries in recent months, prices of swaps insuring against debt default by those nations soared, drawing attention to the troubles and raising questions about whether speculation was worsening them.
This is just absurd.
Let's review what credit default swaps are and how they work:
Credit default swaps (CDS) are a form of insurance. Let's say you borrow money from me. I'm worried that you might default. So I hedge that risk by purchasing a CDS. If you end up unable to pay me back, the seller of the CDS will cover my losses. (The insurance analogy admittedly is not exact, but it suffices for present purposes.)
As the Journal explained, banning the use of CDSs as a hedging device would have adverse consequences, just as banning insurance would:
Any attempt to restrict CDS trades could result in unintended consequences such as more risk for the financial system and higher borrowing costs for a range of nations and companies, some analysts and investors warn.
Restricting credit-default swap trading could push up borrowing costs for various nations if investors feel they have fewer ways to protect themselves if the bonds' prices decline.
The trouble is that CDSs can also be used to speculate. Suppose I think that Greece is going to end up defaulting on its bonds. Accordingly, I don't own any Greek bonds. In order to gamble on the possibility of default, however, I buy a "naked" CDS:
It is legal for someone with no underlying exposure to the credit instrument to purchase CDS protecting against the default of that instrument. This is known as a “naked” position in the CDS. Such positions are taken by those who are making a bet either on a default, in which case the CDS would pay off, or increased perceptions of a default in which case the CDS would appreciate and could be sold to someone else seeking protection against default.
It is this use of CDSs that the regulators are most upset about.
To revert to the insurance analogy, the purchaser of a life insurance policy must have an "insurable interest" in the life of the person being insured, We don't want Tony Soprano taking out an insurance policy on Big Pussy right before he whacks him. Yet, if Tony can do so, his incentive to whack Pussy becomes even stronger.
The problem with CDSs is similar. It is not the CDS itself that contributes to Greece's problem. A bet on a football game doesn't change the outcome of the game, as a poster at Seeking Alpha explains:
If I buy CDS on a company without owning any of the underlying debt, I cannot effect the health of the company. Note that I don't have an insurable interest, but it doesn't matter - the "perverse incentive" is a pipe dream, because I can't act on it.
It doesn't matter how much CDS I buy - I could own a gazillion dollars worth of insurance on the debt of a given company - but that still doesn't give me any say, any seat at the table in a restructuring negotiation scenario. There is a similar analogy with short selling stocks, and it's the reason why people who blame short sellers for the demise of companies are generally nutjobs: short sellers cannot and do not effect the health of a company.
Similarly, CDS levels do not effect the health of a company - they REFLECT the health of a company, or at least the market's interpretation of that health. Some companies will see the value of their CDS widen when people fear for the company's financial health. The CDS is a reflection of the fear, and not the cause of the company's problems. To suggest that panic from widening CDS levels causes companies to collapse is like saying that avoiding marking assets to market makes them worth whatever we want them to be worth - limiting CDS trading would not alter the underlying health of the company, it would only mask it.
So, since one cannot effect the health of the company by owning CDS - since one cannot murder the company (or burn it down) via a CDS position, the "burning down your neighbor's house" analogy goes up in smoke as a straw man fallacy.
Instead, the problem is that the holder of a naked CDS has an incentive to do other things that increase the probability of default. Fraud, manipulation, and the like come to mind.
Banning naked CDSs thus suffers from three problems:
1. It's at best a misdirected prophylactic, If the problem is fraud and manipulation, ban fraud and manipulation. Don't ban gambling, ban point shaving.
2. There is no evidence that holders of naked CDSs have done anything to contribute to the problems faced by Greece and other sovereign borrowers. Indeed, there's no evidence that people are even using them to speculate in Greek bonds. As the Journal explained:
[A] study released Monday by Germany's financial regulator, BaFin, found no evidence that credit-default swaps have been used to speculate against Greek national debt. The study showed the net volume of outstanding credit-default contracts on Greek national debt has remained unchanged since January at about $9 billion. This compares to total Greek government debt of about $400 billion. "The market data do not show massive speculation in CDSs," the regulator concluded.
Instead, as Megan McArdle observes, Greece's problems are entirely of its own making:
I expect that Greek debt will be carrying a substantial risk premium for quite some time, reflecting the fact that the debt is, well, riskier than the debt of bigger and richer nations. The Greek economy remains quite dependent on tourism and agriculture, both of which are subject to rather sudden shocks. Its institutions are often quite weak, and corruption and tax evasion remain serious problems.
3. A ban on naked CDSs would be unworkable, as a poster at Seeking Alpha explained:
In testimony before the House Financial Services Committee on Thursday, March 26, Treasury Secretary Geithner made the following statement regarding naked CDS positions:I know there are strong opinions on this issue, so I say this with some trepidation. My own sense is that banning naked (CDS) volumes is not necessary and wouldn’t help fundamentally in this case. It’s too hard to hard to distinguish what’s a legitimate hedge that has some economic value from what people might just feel is a speculative bet on some future outcome. If we could find a way to separate those two types of transactions from each other, we would have done that a long time ago across a whole range of financial innovations, but it is terribly hard to do. But we will listen carefully to any ideas in this area and understand why people feel so strongly about this.
Our view is that the absolutely essential thing is that there is more capital held against these positions so we never again face the situation where those types of judgments could imperil the system.The position Secretary Geithner is taking ... [is] that it would be next to impossible to differentiate between naked CDS positions and positions intended to hedge underlying exposures.
London's City AM similarly reports that:
The crackdown on speculators also got short shrift from bond market experts who said it would be impossible in practice to unravel the complex interrelated web of CDS positions.
Unless policymakers make it absolutely clear what does and does not count, uncertainty will cause extreme volatility, and they run the risk of ending up with worse problems than they started with,” said Simon Thorp, head of fixed income at Liontrust Asset Management.
Update: Todd Henderson blogs that:
As I explain in this paper, credit derivatives are merely a financial tool that can be used by those exposed to credit risk, say a default by the Greek government or General Electric, to share that risk with others. This lowers the costs of borrowing and helps spread risk. In addition, third parties with no exposure to the particular credit risk can bet on whether the Greeks will default. These secondary-market transactions are the same as an individual buying stock in General Electric betting it will rise. Importantly, these bets provide a liquid market for credit risk, which lowers the cost of hedging for those with primary exposure, and provides the market with better information about whether Greece or General Electric is a good credit risk. Those who might lend to the country or company, those conducting other business with it, and those who might face the risk of default in other ways, can use this information to better plan their activities. For instance, those disbelieving a country or company’s claim of financial soundness, say because of funny accounting (think: Enron or, dare I say, America) can use credit derivatives to short debt, something that was impossible before credit derivatives were invented. This makes debt prices more accurate and holds borrowers, be they sovereigns or corporations, better to account.
Of course, there is the possibility for abuse. Another New York Times article from a few weeks ago highlights the possibility for abuse in this market. (Note the parallel between the conflict of interest across departments at Goldman Sachs and those in the investment analyst scandals from a few years ago.) But abuse is possible in all markets, and everyone should be in favor of vigorous enforcement against those who try to manipulate markets or trade on undisclosed conflicts of interest. The existence of the potential for abuse, however, is no more an indictment of credit derivatives generally than it is of the stock market or any other useful tool of society than can sometimes be abused.
It is the ultimate irony that politicians are blaming their problems on a tool that helps reveal their tricks and mistakes. This is akin to a burglar blaming an alarm system for being caught. Sure, the burglar might have been better off without it, but the homeowner and everyone else is glad it was installed.
