Thursday, February 18, 2010
A Chicago-Style solution to the Bond Vigilantes: He pulls a knife, you pull a gun, He pays the offer on $1bln of CDS, you hit the bid for $10bln.
In my previous entry I wrote about how CDS have been a useful tool for the Bond Vigilantes who have launched a speculative attack on Greece and through Greece the very concept of the Euro. After a brief relief rally based on the EU meetings last week the Euro is falling off again and the Greco-German bond spread has yet to tighten. It looks as though the Bond Vigilantes may make another run at the beleaguered Greeks in an attempt to push them out of the Euro or to force the hand of the EU.
I would like to make a modest proposal to the Finance Ministers of the EU countries for how to deal with this problem: sell the hell out of Greek sovereign Credit Default Swaps.
Of all the measures that the EU and its member governments have been considering I think this would be the most effective. The first question to ask is what are the things standing in the way of EU action today. I think there are two issues. The first is moral hazard and the second is political will. The moral hazard issue is primarily one of signalling. A direct rescue of Greece sends a message to both the sparring parties within Greece itself as well as to those next in line for speculative attack they don’t really need to come to terms with their fiscal and economic policies because they can rely on a bailout. Interestingly the existence of the possibility of a bailout has the effect of entrenching the parties that need to cooperate in order to prevent one. The other issue is political will. The French and German voters would rather throw Greece out of the Euro System than have to pay for their costs.
So what are the tools that the EU is considering to use to assist Greece? The governments of Germany and France, the only ones really capable of providing aid are quiet on this point. Poland however said that the kinds of assistance that are being considered are loan guarantees and straight cash transfers. These are very blunt instruments. Cash transfers are probably only politically possible in an extreme emergency and perhaps only one for which the Greeks are not demonstrably culpable. The problem with loan guarantees is that they are a blunt instrument. For sure they would lower the borrowing costs to Greece on which the bonds which were guaranteed but they are kind of an all or nothing solution. As such, they would have the effect of delaying the necessity of the Greeks themselves reaching a compromise and might make default more likely. Markets beyond Greece would probably also assume they would be rescued and thus would have similar problems addressing their issues. Thus the EU is damned if it does and damned if it doesn’t.
EU government intervention in the CDS markets I think would be an excellent way to square these circles. CDS purchases require no transfer of principal except in event of default. That is to say the governments involved would not have to write checks to Greece. Rather they would simply be lowering the risk to others of writing those check and they would get paid for the serivce. This would be easier to accomplish politically than straight cash transfers as there would be no outflow from the treasury and no need to use taxpayer funds. Indeed if there were no Greek default this would be a net win for the taxpayers.
The economic effect would be very similar to establishing loan guarantees an intervention in the CDS markets would be much more flexible. The similarity would come from the fact that anyone who bought a Greek CDS would then be able to buy Greek bonds with no risk. This would have the effect of increasing demand for Greek paper and thereby lowering the funding costs for the Greeks and narrowing their deficit. Instead of being on a single issue however the Greek CDS could be used to protect any Greek paper and so might prevent some potential sellers from panicking and would calm the markets more generally. This is one source of flexibility, the other is that once the crisis had passed the governments could simply go out and buy the CDS back with minimal market impact. Withdrawing a loan guarantee would be much more problematic.
Intervention in the CDS markets would also have excellent signalling characteristics. For the parties within Greece the EU governments would maintain their studied ambiguity. CDS intervention is a partial and reversible loan guarantee. The parties within Greece would have some confidence that they were not alone but would not be able to completely rely on the assumption of a bailout. On the other hand for speculators to know that they were being sold insurance against an event that the seller could himself singlehandedly prevent. It would be like God selling you hurricane insurance. This would make the trade of gunning against Greece a massively more risky undertaking. If the intervention were sudden and massive it might have the effect of creating a short squeeze against the speculators and forcing them out of the trade altogether. I'm pretty sure the German government and the ECB are better capitalized than the top fifty hedge funds put together. I think this would have the effect of quelling the speculative attack on Greek debt and would give the Greeks some time for their reforms to work.
Just a modest proposal from www.wallstwtf.com