Credit Default Swaps in the crosshairs

What’s at stake: The recent difficulty faced by Greece in rolling over its national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states. Leaders of the G20 group of countries will consider a European initiative to crack down on speculative activity in derivatives trading, George Papandreou, Greek prime minister, said in Washington on Tuesday. Mr Papandreou was speaking after a meeting with Barack Obama where he outlined the initiative planned jointly with France, Germany and Luxembourg.

Wolfgang Münchau writes that a generalised ban on so-called naked CDSs should be a no-brainer. A naked CDS purchase means that you take out insurance on bonds without actually owning them. But a universally accepted aspect of insurance regulation is that you can only insure what you actually own. Technically, CDS are not classified as insurance but as swaps, because they involve an exchange of cash flows. The CDS lobby makes much of those technical characteristics in its defence of the status quo. But this is misleading. Even a traditional insurance contract can be viewed as a swap, as it involves an exchange of cash flows. But nobody in their right mind would use the swap-like characteristics of an insurance contract as an excuse not to regulate the insurance industry. The fact that, unlike insurance, CDSs are tradeable contracts does not change the fundamental economic rationale.

Felix Salmon writes that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. There are lots of very good fundamental reasons why people might want to buy credit protection on Greece without owning underlying bonds. Maybe you are or will be owed money by an arm of the Greek government. Maybe you have businesses in Greece, and are worried that in the event of a default you won’t be able to repatriate your profits there. Maybe you intend to enter into a contract with a Greek company who you trust and understand, but want to hedge sovereign risk which is out of that company’s control. These are not “purely speculative gambles”, they’re ways of facilitating capital flows into Greece. And one of the big problems with debt markets is that, especially during times of stress, they become very illiquid.

Rajiv Sethi argues that expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic. Any entity that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to roll over its debt periodically. Such an entity could be solvent and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling. This is the case for state and local governments in the US, as well as individual countries in the eurozone that do not have the capacity to issue fiat money. The main "assets" held by such entities are claims on future tax revenues, which are obviously not marketable. In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic. And as John Geanakoplos notes CDS contracts allow pessimists to leverage much more than they could if they were to short bonds instead. The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.

Leigh Caldwell questions the feasibility of banning naked credit default swaps. The proposal of banning naked CDS, while eliminating a form of moral hazard, would probably also eliminate the whole CDS market. You could just say that people shouldn't sell bonds if they are going to take out a CDS on them. But remember that the whole point of bonds is that they can be sold: if I were planning to hold a bond forever, there are other ways to invest money and get a better return.  Robert Waldmann on the other hand argued in a 2008 post that it is trivially easy to do so.

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