Credit Default Swaps

[Article printed in The Economist. It aptly explain the heart of the issue regarding credit default swaps on government debt and politician's misguided attempt to ban them.]

Smokescreen:
Blaming speculators for sovereign-debt woes is misguided. Banning them would be worse


GREECE had a budget deficit of 12.7% of GDP in 2009. It has a record of dodgy accounting. Its own leaders acknowledge how dire its fiscal situation is. George Papaconstantinou, the country’s finance minister, summed it up pretty well last month. “People think we are in a terrible mess. And we are.”

That hasn’t stopped his boss, George Papandreou, and other European leaders from jabbing fingers elsewhere. To judge by this week’s political rhetoric, the blame for Greece’s woes lies largely with speculators, who stand accused of buying sovereign credit-default swaps (CDSs), a form of insurance against government default, in the hope of profiting from jitters about sovereign debt. “Unprincipled speculators are making billions every day by betting on a Greek default,” said Mr Papandreou in a speech in Washington, DC.

The wheels of policy are now turning. The European Commission has said it will examine the case for banning “naked” sovereign CDSs, in which buyers of protection on government debt do not actually own any of the underlying bonds. A European ban would not do much good on its own: trading would simply move to other markets. The official American response to Mr Papandreou has been tepid. But the issue is on the G20’s radar. The Financial Stability Board, which is co-ordinating international financial reform, thinks that tighter rules are likely.

Some reform of the market for sovereign CDSs is needed. Like other credit-default swaps, there is a strong case for moving these over-the-counter instruments on to central clearing-houses, which stand between buyers and sellers and reduce counterparty risk. Sensible changes of this kind are already in train in Europe and America. But the idea that speculators are to blame for Greece’s troubles is wrong-headed, and the solution of banning naked sovereign CDSs is even worse.

First, the diagnosis. The case against buyers of sovereign CDSs is that by driving up the price of insuring against default, they cause spreads on underlying cash bonds to widen, making borrowing more expensive and bringing default—and a big payout—closer. That drives up the price of insurance further, setting the cycle in motion again. The problem with this analysis is that the tail is far too puny to wag the dog. There are $9 billion of net Greek sovereign CDSs outstanding, compared with more than $400 billion of Greek government bonds. It is a similar story in other countries under pressure. According to the Bank for International Settlements, the proportion of net CDS positions to government debt is highest in Portugal, at just 5%. Moreover, CDS and bond prices have tended to move together, rather than one driving the other.

Naked self-interest

Even so, surely it cannot be right for people who do not own any government debt to profit from sovereign distress? Actually, it can. When states get into trouble, other borrowers suffer too: taxes rise, economies slow. So investors in Greek companies have legitimate reason to protect themselves against Greek sovereign risk. If they cannot, they will simply charge companies a higher risk premium instead. Buyers of protection also have to find sellers—banks, say, or hedge funds. But sellers want to offload their risk as well. If sellers are not allowed to buy protection themselves, investors will find it harder to hedge. If so, banning naked CDSs could end up making it more expensive for governments to borrow.

There is a long tradition of shooting messengers who bring bad news. But the simple explanation for rising borrowing costs—Greece’s finances are tatty—makes far more sense than the complex, politically convenient one. The sovereign-CDS debate is a smokescreen to obscure an unpalatable truth.