Defenders and Demonizers of Credit Default Swaps

The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states.

A cogent case for prohibiting the use of credit default swaps to make directional bets has been made recently by Wolfgang Münchau in the Financial Times:

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer...

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point...

Economically, CDSs are insurance for the simple reason that they insure the buyer against the default of an underlying security. A universally accepted aspect of insurance regulation is that you can only insure what you actually own. Insurance is not meant as a gamble, but an instrument to allow the buyer to reduce incalculable risks. Not even the most libertarian extremist would accept that you could take out insurance on your neighbour’s house or the life of your boss...

I do not want to exaggerate the case for a ban. This speculation is neither the underlying cause of the global financial crisis, nor of the eurozone’s underlying economic tensions. But naked CDSs have played an important and direct role in destabilising the financial system. They still do. And banks, whose shareholders and employees have benefited from public rescue programmes, are now using CDSs to speculate against governments.

Felix Salmon objects to this reasoning, arguing that trade in naked credit default swaps adds liquidity to the market, which in turn makes borrowing easier in times of stress:

One of the big problems with debt markets is that, especially during times of stress, they become very illiquid. Many bankers have spent many hours trying to explain to emerging-market finance ministers that just because their bonds are trading at a certain level in the secondary market, that doesn’t mean they can issue new bonds at that level, or even at all.

But it turns out that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. Which is yet another reason to laud the notorious buyers of naked CDS protection, rather than demonizing them.

Sam Jones also rises in defense of naked CDS contracts, though for somewhat different reasons:

Here’s the rub: there is a palpable social and economic benefit to naked CDS positions. And what’s more, that benefit has perhaps never been more strongly borne out than as in the recent case of Greece.

First, some context via a trip back in time: back to 2004, when the Euro was a more lustrous specie than it is today, and when credit default swaps were breaking into the mainstream... some hedge funds in those more moderate times spotted an opportunity for a trade... buy default protection against the eurozone’s weakest member states, the bonds of which had no place trading so close to German bonds. Buy Italy, buy Spain, buy Greece. And do so, naturellement, au naturale...

What they saw happening was an inevitable re-risking of the eurozone. Italy could not possibly be priced so close to Germany indefinitely, and at some point, during the lifetime of their ten year CDS contract, spreads on Italian bonds would widen... The result would be –- if done well — a perfect sovereign basis trade. And because the CDS contracts required so little initial outlay, it could be done on a huge scale, to significant profit...

In 2008 and 2009... the logic of the trade returned with more heft... Last year, big hedge funds were significant buyers of CDS protection on risky EU states: in particular, they bought CDS against Greece in anticipation of a budget blowup that would send the yields on Greek bonds soaring at some point in the next few months...

What, though, to return to the point of this post, of the broader economic and social benefit beyond well-heeled Mayfair and leafy Connecticut?

Firstly, any naked CDS buying... occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks... Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe...

Secondly... hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

So the argument here is that while hedge funds may have raised the cost of borrowing for Greece in 2008-09, their current actions are making borrowing easier and less costly.

Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider.

Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling.

This is the central insight in Diamond and Dybvig's classic paper on bank runs, and is a key rationale for deposit insurance. William Dudley highlighted the importance of such effects in a speech last November:

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. The main "assets" held by such entities are claims on future tax revenues, which are obviously not marketable. In this case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.

What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.

Whether or not these considerations are relevant in accounting for the troubles faced by Greece is an empirical question. But it does seem to be within the realm of possibility. At least the Chairman of the Federal Reserve appears to think so:

Addressing concerns that financial firms have been engaging in trades to bet on a Greek default, Bernanke said that "using these instruments in a way that intentionally destabilizes a company or a country is counterproductive, and I'm sure the SEC will be looking into that."

Felix Salmon hopes that Bernanke "was just being polite to his Congressional overlords, rather than buying in to this theory." I hope, instead, that he is taking the theory seriously.

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Update (3/7). Felix Salmon has another post dismantling a New York Times report on the issue. The Times is an easy target, and it is true that their reporting has been riddled with errors and inconsistencies, including a bizarre failure to distinguish between the systemic effects of selling credit default swaps without adequate capital reserves (as AIG did), and those of large scale naked CDS purchases (as hedge funds are alleged to have made).

But what I would like to see from Salmon is a clearer distinction between the use of CDS contracts for hedging (which even Münchau would probably agree has beneficial effects on the ease and cost of borrowing) and their use for speculation (which need not). The Sam Jones post does this, and makes clear that if current hedge fund activity is holding down CDS spreads, then prior activity must have had the opposite effect. One may then ask whether Greece (and its fellow PIGS) would be in such a precarious position without this prior activity: this is an empirical question that has yet to be convincingly answered.

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Update (3/8). The comment thread following Mark Thoma's post on this is excellent. Leigh Caldwell questions the feasibility of banning naked credit default swaps and links to this post. Robert Waldmann argues that it is trivially easy to do so, and links to his September 2008 post making the case. Paine wonders whether the bank run model is adequate (and seems to be the only one taking the multiple equilibrium problem seriously). Bruce Wilder is concerned that insuring bonds against default destroys incentives for supervision and control. Gump explains the structure and incentive effects of CDS contracts with greater clarity than I've seen anywhere else. And mrrunangun makes an interesting proposal. There's plenty of criticism of my post, but I very much enjoyed reading the entire thread.

Also, I have edited the Münchau quote to remove his quip about banning bank robberies (this was a rhetorical excess, and unhelpful in advancing debate on the topic).

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Update (3/8). Felix responds on empirical grounds, and he may well be right about Greece. But the following claim is clearly incorrect:

Countries have essentially no limit on how much they can tax or cut spending in order to make their debt repayments: just look at Latvia right now. I’m not saying they should always raise taxes and cut spending rather than default, of course — I’m just saying they can. Companies are in a very different boat, and if they can’t find the money to make a payment then they default: it’s as simple as that.

The problem with this is that while governments can change expenditure policies and tax rates, they do not have direct control over revenues or actual expenditures, which depend on the level of economic activity. If attempts to raise revenues are too contractionary, the deficit may increase rather than decrease. As Paul Krugman points out in this post, Spain had a budget surplus just three years ago, but "is running huge deficits now... a consequence, not a cause, of the crisis: revenue has plunged, and the government has spent some money trying to alleviate unemployment." Any attempt to raise taxes or cut spending in this environment could make it even harder for the country to meet its near term debt obligations. There is also political viability to consider: a government has to stay in power if it is to do anything at all.