It is very difficult to construct an argument that defends the practise of buying insurance against a sovereign default, when you have none of the bonds.  But informed letter-writers to the FT have been doing just that, in response to Munchau’s assault on the practise.  They say:

There are sound reasons for buying CDS without owning the underlying bonds. For example, an investor might select certain Greek corporate bonds and hedge the generic risk on the Greek economy with sovereign CDS. That could increase the supply of credit to Greek companies, which is hardly tantamount to “bank robbery”, in Mr Münchau’s striking but misleading phrase.


However, the CDS markets in government bonds are small in relation to their underlying bond markets and they are unlikely to be responsible for any such destabilisation. Rather, what has destabilised the government of Greece is, first, eye-watering levels of debt, second, near-fraudulent accounting practices, and third, a frightening inability to match spending with revenues.

Here are three letters.  You may not have permission for them (subsribe to the FT! it is worth it!) But the new blog FTDotComment has a good article on the subject by James MacKintosh:

In Greece, though, it does not appear to be manipulation by hedge funds which is causing the wide bond spreads. So finance ministers should address their problems at home, before trying once again to turn speculators into scapegoats.

Tim Worstall has an example of the Greek attitude to paying your way – taxi drivers kicking up about no longer being able to evade taxes.  Could Richard and Tim actually agree on this one? And FT Alphaville has an educational insider’s view as to how the hedge fund trade worked.

My problem is that too many people conflate “betting on something happening” with “making something happen”.  A bad-taste example: in the City, when Mother Teresa, John Gielgud, Frank Sinatra and Pope John Paul were all ancient and tottering, I am sure you could have seen bar-side bets on who would pop their clogs first.  Yes, very distasteful.  But buying a load of the “Teresa goes first” index would not make the old lady keel over, unless you took winning very seriously indeed and tried to do something about it.

Yes, you can get situations where the feedback loops make speculation cause the outcome – such as selling hard at a rights issue. But it seems doubtful in the case of Greece.  The Greek bond market fell when the government revealed that the books had been cooked.  Although the IEA is always unnaturally suspicious of governments in all their forms (and insufficiently suspicious of markets), I tend to believe them when they say:

The Greek welfare state has become a hotbed of rent-seeking, with middle-class working-age households receiving more in cash benefits than the poor. At the same time, Greece has Western Europe’s largest shadow economy.

This was not all suddenly invented by a rapacious hedge fund manager.


6 thoughts on “Defending the CDS market

  1. “Tim Worstall has an example of the Greek attitude to paying your way – taxi drivers kicking up about no longer being able to evade taxes. Could Richard and Tim actually agree on this one?”

    Of course: as Richard would point out, I believe that only the little people should pay taxes.

  2. I am inclined to follow your guidance on the Greece situation (at least until I have had the chance to work through all the links you provided) – arresting the “usual suspects” is not exactly good liberalism.

    But I am not sure your death pool analogy was quite fully featured: it would be a better parallel to the general responsibility of the moneyjuggglers if you imagined it was the administrators and senior medics of the hospitals in Calcutta, London, Los Angeles and Rome dipping into their geriatrics budgets to fund their punting on the life expectancy of their famous patients.

  3. In the Greece case I don’t think the CDS market is causing the instability in the underlying bond market. The CDS are just too small compared to the notional value of the total bond stock. Moreover, as FT Alphaville points out it is the unhedged banks scrambling to cover their exposure i.e. French, Swiss and German banks who have the most exposure. A bit ironic that French banks are helping to cause the widening CDS spreads that Christine Lagarde is complaining about. Therefore, in this case CDS are acting as the canary in the coalmine and fundamentals are driving the underlying bond market.

    Whether fundamentals justify the Greek bonds spread over German bunds when they are denominated in the same currency to me is an irrational market. It is unthinkable that the other euro members would stand back and allow them to default. Moreover, would the ECB really refuse to accept the eligibility of the government bonds of a member as collateral? I think not.

    I think the naked CDS issue is one that will continue with European politicians using it as a convenient distraction. Betting against banks and corporates is one thing but if powerful financial institutions start betting against governments they are playing with fire. Governments can fight back and change the rules at any time time and close the trades.

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