After Wolfie Munchau went off on one about the wickedness of naked CDS’s, the letter pages of the FT have enjoyed a slow-motion explosion of discussion (I love the pre-Internet, it is so civilised.  I wish the ‘publish’ button had a one-day delay, the writing would be so much better).

This is not chronological.   But the intention is to refute the knee-jerk TUCist view:

“At the ETUC, we’re increasingly concerned that Greece seems to be alone to face a renewed wave of financial market speculation, as heavily leveraged speculators take advantage of Greece’s debt crisis, exacerbating the country’s situation for a heavy profit.”

The TUC’s views are hardcoded into their thinking.  But responsible governments ought to think more deeply, and this is why Buttonwood is right to criticize the “axis of feeble reasoning” behind this letter:

“we must prevent speculative actions from causing so much uncertainty on the market that prices no longer provide accurate information and state financing reaches a fundamentally unjustifiable high level”

So speculators cause the problems they are trying to profit from. This may be called ‘reflexivity’ (see this comment on Rajiv Sethi’s page – hattip Alex commenting here).   Under certain conditions, speculation can become destabilising, is the view.  The other view, as Buttonwood explains, is that the reason Greeks borrow more expensively is, um, their inability to run their affairs properly:

“Greece has a huge budget deficit, a debt-to-GDP ratio of more than 100%, a poor credit rating and a record of restating its accounts for the worse. A yield of 6% doesn’t seem too unjustifiable in the circumstances*”

And there are real problems with banning CDS.  On to the letters.  In this one:

“To ban CDS altogether would virtually remove a bank’s ability to manage credit risk; to ban naked shorts would completely remove the ability to find proxy hedges for the huge array of credit risk that cannot be sold or directly hedged . . . The CDS debate will continue as long as there is a failure to distinguish between market manipulation, speculation and risk management. Blunt limits or bans will affect all three”

Now this one:

“A liquid market needs lots of buyers and sellers, and an observable price. If a buyer knows that there is a market in credit default swap protection, they can buy with the knowledge that even if they can’t sell their bonds, they can protect themselves from losses. Hedging would be more expensive and less liquid if naked shorts were banned, which would make investors demand a bigger premium for liquidity, making funds more expensive . . . Naked CDS do not reduce liquidity; it is not a zero sum game. Underlying the arguments is often an ethical disdain for speculation. But the very distinction between “good” investing and “bad” speculating is spurious.”

And this one argues that Speculators Force countries to Mend their Ways:

“Speculation performs a vital task in the economy – that is, punishing those borrowers who have difficulty putting their house in order, Greece being a prime example. It was hardly unexpected that the Maastricht criteria would be conveniently ignored by politicians when all or most of the eurozone countries fail to abide by their own holy rules . . . Speculators then perform the role that politicians find difficult or impossible – namely to force countries to mend their ways. Indeed, had speculation been even more prevalent, the current situation might not have arisen, since interest rate spreads would have increased sooner, forcing countries to react.”

Finally, the FT itself has offered its own stout opinion:

“Proposals by European leaders to crack down on sovereign credit default swaps serve an important purpose: to deflect attention from the fact that their inability to deal with the Greek debt crisis is a trap of their own making . . . “Naked” CDS, where the buyer does not own the underlying bond, are often likened to insuring one’s neighbour’s house against fire. But while arson is easy, no speculator has deep enough pockets to bring down Greece at will . . . A ban, if it could be enforced, would also confine hedging to a world of barter, requiring one to find those with the opposite hedging needs of one’s own without intermediates”

That is my view, too.  An ethical distaste for speculation is hoping to find a Divinely Convenient Coincidence: “What I find abhorrent is also bad for the world”.   In this case, it doesn’t work out that way.   People betting on the failure of some activity or entity may not seem like an honourable way of making money.   But prices being too high or implying too great a chance of success are also a massive con; they force investors to pay more than they should for something.   In the credit crunch, HBOS railed against ‘shorters’ causing their bank share price to fall.  But wanting their share price to be high when their balance sheet and future profits were f***ed was a grossly dishonest aspiration; it was hoping that countless pensioners would be suckered into paying too much for near-worthless equity.

So too with Greek bonds.  They don’t deserve a high price.  And insisting that ricketty, balsa-wood shacks be granted the right to fire insurance with miniscule premia is daft.

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5 thoughts on “Banning CDS – a veritable linkfest and stout opinion

  1. Honest question: Haven’t CDS’s only been in existence since the 1990s? Why is the idea of returning to the status quo ante 1990 soeen as completely ludicrous?

    Why are they suddenly ‘vital’?

    1. A good question

      (thinks: “**** it it’s Friday afternoon, I only want obviously bad points now”).

      You could also say the same for 1-pip FX spreads; a lot of cross border lending; and so on. We got by without these things in the 1980s and grew at 3%, so why need them?

      My answer would be that the existing economic structure through sheer path dependence probably depends more on them than we realise. A lot of lending etc is currently premised on there being certain escape routes, ways of mitigating risk, and so on. Perhaps it is only because of such marekts that the Greeks COULD borrow this much in the first place, because their existence gave confidence that the risks could be mitigated.

      I think a crude analogy; we got by without email in the 1980s. But taking it away would destroy a lot of businesses because they are premised on it being there.

  2. So here’s an interesting thought about this feedback loop business. Market participants process information and turn it into expected prices; market prices then reflect a weighted aggregate of those expectations. What happens when market participants start to treat the market price as a piece of information along with all the others? (Arguably, this is what the triumph among financial operators of some form of the EMH and MPT has done.)

  3. I am still unconvinced that naked CDS serve any useful purpose. Implicit in the letters is the idea that spreads in the CDS market are driving the yields in the underlying bond market. I think this is a dangerous assumption to concede because the CDS market is tiny compared to the notional value of the underlying bond market. Over anything other than the very short-term fundamentals must drive the the Greek bond market and not the CDS market. The idea that to hedge Greek credit risk you need to proxy hedge through Greek sovereign CDS is surely ridiculous.

    If you believe that in the long-run CDS spreads can’t influence the yields on Greek government debt then banning the naked CDS will only change the short-term dynamics but leave the long-term unchanged.

    However, to say that the CDS market is somehow shining light on the fundamentals as some hedge funds claim is to my mind conceding that the CDS market is driving the yields on the underlying market. Therefore, if that claim is true then the CDS should be cleared through an exchange with the writers posting sufficient capital.

    I don’t like the idea of naked CDS, but never forget they are providing a convenient target for populist politicians.

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