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


Anonymous said...

Sorry Ken,

There are two flaws in the argument

a) Governments are in the business of governing citizens, they are not in the business of financial speculation. Lets say the German/Greek government follows your prescription and buys CDS, imagine if there is an unpredictable natural disaster like an earthquake, the government will not only have to pay for disaster relief but also pony up the post disaster CDS payment spike.

b) Most Hedge Funds are able to operate only because they have a bit of secrecy. Imagine governments getting parliament approval before buying a contract (add audit bureaus, compliance committees to the picture) or alternatively imagine government operating cloak and dagger like the CIA. Both of these models are bad for the individuals.

Blaming the CDS guys is equivalent to blaming the short sellers, short sellers are in the business because there is something fundamentally wrong with the firm/country. The Greek government needs to kick some @ss and get its fundamentals in shape, not try and out beat the CDS speculators.

Ken said...

Thanks for your comment anonymous. I'm not sure I agree with you here. I am reccomending that the governments sell CDS rather than make cash transfers and loan guarantees. In the event of a natuaral disaster the CDS sellers would only have to pay out in event of default which would not actually happen because, as you point out, they would provide relief funds. As a result they would actually win to the trade as they would in the event of a full bailout and could use some of their winnings to finance the bailout.

I fully agree with you that short sellers are an effect not a cause of bad management and I also fully agree that the issue at the heart of this is the poor performance of the Greek government. I don't think the analogy of short sellers to CDS buyers is appropriate.

Short sellers create excess supply of equity and push the price down but this has little direct effect on the fundamentals of the underlying business. CDS buyers on the other hand have the effect of crowding out the government from the market in its own debt. This has the effect of raising the rates at which the government funds which does have an effect on the deficit, which is the original problem.

I go into this quite a bit in the previous entry.


Ken said...

Oh, and don't apologize for commenting. I'm perfectly happy to admit mistakes or withdraw or edit posts when people point out serious errors or ommissions. Thanks again.

Anonymous said...

These guys just can't be serious:

“We are not looking for money from other countries,” Papandreou said at a conference in London today. “What we are simply saying is we’d like to borrow on same terms as other European and euro-area countries.”

That or they just actually want the EU to call their bluff and give them the bounce.

Anonymous said...

Hi Ken,

" CDS buyers on the other hand have the effect of crowding out the government from the market in its own debt. This has the effect of raising the rates at which the government funds which does have an effect on the deficit, which is the original problem. "

In case there is a natural disaster then the govt. will have to divert funds to address the natural disaster. CDS are typically denominated against a bond. Imagine if the govt's finances are squeezed and it tries to refinance/negotiate on the bond, it will face a double wammy of the bond principal plus the CDS payment.

" Short sellers create excess supply of equity and push the price down but this has little direct effect on the fundamentals of the underlying business. "

By depressing the price of equity, they signal to the bond holders and banks that things are not ok with the firm, thereby increasing the cost of financing of the firm