There is an old joke common to all communist countries - Cuba, the Soviet
Union, China et al - and it has been invoked to describe a succession of
communist leaders from Josef Stalin to Li Peng, and goes thus:
Citizen: "XYZ is an idiot."
Police: "We arrest you for making that statement."
Citizen: "Why? You think XYZ is not an idiot?"
Police: "No that's true; but we arrest you for revealing a state secret."
That old joke has now been recycled by the intellectual successors of the
global communist movement, namely the Europeans. Aghast with the market
volatility associated with the
likely bankruptcy of one of their member states - Greece - the Europeans have
taken a leaf out of the old communist playbook and blamed the market rather
than focus on (or even address) the fundamental problems dogging Greece.
As Bloomberg news reported this week:
Michel Barnier, the European
Union's financial services commissioner, said the European Commission will
investigate trades in sovereign credit default swaps [CDS] in the wake of the
Greek debt crisis.
"We're working on the fundamentals of derivatives, to understand who does what,
and in CDS we're looking at the aspect that relates to states," Barnier said in
an interview in London today.
European leaders have said trading in the contracts, which pay cash if the
company or government they relate to defaults on their debt, fuels speculation
that can distort market perceptions. The German Finance Ministry yesterday said
the over-the-counter products must be reviewed following the reaction of
financial markets to the Greek debt crisis.
"We're determined to work within the framework of the G-20, this is not
something we're doing alone. The Americans are doing the same," Barnier said,
referring to the Group of 20 nations.
German Chancellor Angela Merkel's government is considering ways to "tighten up
rules" in the sovereign CDS market. French Finance Minister Christine Lagarde
said Feb 17 "we should examine the suitability" of credit swaps.
The cost of contracts on Greece rose to a record 428 basis points last month,
according to CMA DataVision in London. That meant it cost US$428,000 a year to
insure $10 million of debt for five years. The swaps were quoted at 313 basis
points today (March 2).
By now it has almost become a common
occurrence for politicians across Europe to demand "crackdowns" on various
aspects of the market - the ban on short-selling for example that was pretty
much global in the fourth quarter of 2008 was first promulgated in the United
Kingdom by a government anxious to avoid its banks being pushed to the brink by
falling stock prices. No matter that the UK ban on short-selling proved
ineffectual because the short-sellers had been correct - that is, that major
banks such as RBS had actually run out of capital and eventually had to be
nationalized.
So revealing the state secret of bankrupt banks, first done by the
short-sellers, was eventually to prove beneficial to the government for taking
decisive action to stabilize its financial sector.
As I wrote after the US ban on short-selling (see
A stone for Chris Cox, Asia Times Online, July 19, 2008), avoiding the
free functioning of markets is akin to press censorship - the truth doesn't
change even if the ability of reporters to publish it does. Short-sellers have
a useful function as they take asymmetric downside risks, that is, they can
lose much more than their committed capital, as against a "long only" investor
who can, at worst, only lose all the capital he puts in.
In the above example, the CDS market has been unfairly targeted as the source
of the sovereign debt problem in Europe, when in effect movements in European
sovereign CDS levels are essentially the canary in the coal mine; they serve a
useful function of showing what a privately negotiated insurance contract on
these sovereign issuers would likely cost. Or put another way, they are
effectively the messenger of good and bad tidings - and as Sophocles wrote in Antigone,
no one likes the messenger who brings bad news.
This ability for private pools of capital to offer (or purchase) insurance on a
variety of issuers is actually even more important in today's market
characterized by substantial government/central bank intervention measures that
will eventually have to be removed.
As the Financial Times reported on March 4:
On January 28, a cloudy,
drizzly day in Athens, Goldman Sachs played host to ... 10 bankers, asset
managers and hedge fund analysts, [who] ruminated on the future of the Greek
economy - and of course, how to make money from it.
Events since - a vicious collapse of confidence in the Greek debt market - have
made some of those present, millions. But there has been a price ...
... Hedge funds have played a calculated trade that began not in January, but
many months previously. Rather than destabilizing the Greek government, say
several large hedge fund managers, their trades have been supporting it - and
some of Europe's largest banks to boot. The trade began in scale in 2009, when
hedge funds bought up large amounts of CDS protection against Greek debt, in
anticipation that markets would soon wake up to Greece's debt problems and
hence look to the CDS market to hedge the risks.
... The hedge funds buying up the CDS protection, however, did so without
owning the underlying bonds. This so-called "naked" CDS trading is a particular
issue regulators are keen to look into. The funds buying up Greek CDS in 2009
were not expecting to profit from an actual Greek default.
"This is all about the banks," a fund that participated in the trade, but which
declined to be named, said. "The point is that they've been desperate to hedge
their huge exposures to Greek bonds. It's their desperation that's pushing up
spreads. Whereas we're in the market as sellers. We're pushing things down."
Hedge funds anticipated that if the Greek government's financial situation
deteriorated - as they expected - then the owners of the approximately $300
billion of outstanding Greek bonds, would be desperate for credit protection,
or else would look to sell their holdings. Having already locked in credit
protection cheaply, if such a situation were to occur - as it did - the hedge
funds would then be in a position to write credit insurance at a significant
premium to panicking banks, or else buy up Greek bonds being dumped in the
market for a decent yield. In the event, the trade paid handsomely.
In effect, the flutter that European governments have unleashed is, at its
peak, wrong-headed simply because their pre-designated criminals, ie the hedge
funds, are actually the heroes of the story. They purchased something early
when it was cheap and offered it out when things got rickety and expensive.
In any event, the European efforts to curtail CDS trading are a matter of
"careful what you wish for" - as the Financial Times reported, also on March 4:
At
a conference in London this week, one hot topic for discussion among hedge fund
managers was the risk of a clampdown on trading in credit default swaps, writes
David Oakley in London. A second key point of debate, however, was what hedge
funds will do if they are no longer able to buy and sell sovereign CDS - and
how that might affect the price of other assets?
Hedge fund managers say one simple alternative trade to shorting Greece, where
a near collapse in the debt markets has prompted moves to tighten regulations
on CDS trading, is to short the eurozone as a whole. This could be done by
selling the euro against the dollar in the foreign exchange spot markets or
buying a put in the options and futures markets, which gives the buyer the
right to sell the euro at a certain price. If the euro falls, then the buyer is
in the money and makes a profit.
Shorting the euro has become very popular in recent weeks as some hedge funds
have decided against trading the Greek CDS market because of worries over a
regulatory clampdown.
Even as these events roiled markets, a
positive development also came about. When the Greek government finally
accepted the signals from the market and imposed new austerity measures it was
able to sell new longer-dated debt successfully. As the Wall Street Journal
reported on March 4:
The Greek government's offering for a 10-year bond
attracted about 14.5 billion euros (US$19.86 billion) in bids and the books
have closed, the head of the country's debt-management agency said. The new
issue priced at three percentage points over the benchmark risk-free mid-swaps
rate, reflecting the market's demand for a premium. This is a risk premium of
3.26% over German bunds, the eurozone's benchmark
An issue size of 5 billion euros for the new 10-year bond "would be a good
result" but not enough to fully cover Greece's near-term funding needs, said
UniCredit strategist Luca Cazzulani. Greek bond yields in secondary markets
moved up on the news. The yield spread between Greek 10-year government bonds
over equivalent German government bonds widened to around 3.03 percentage
points from Wednesday's 2.92 points.
The cost of insuring Greek sovereign debt against default also rose slightly.
The price of Greece's five-year sovereign credit-default swaps increased to
3.050 percentage points, from 2.945 points, representing a 10,500 euro increase
in the annual cost of insuring 10 million euros of debt for five years.
As the article makes clear, once the "pound of flesh" of higher interest
payments and greater focus on cutting debt becomes clear, markets move back to
a semblance of normalcy. Interestingly, the price at which bonds were sold is
very similar to the insurance cost in the CDS market: a reminder of how
effective the CDS market has been in terms of highlighting and pricing real
risks.
Longer-term, the trajectory of whatever happens in Greece will perhaps echo the
developments in Iceland, which has seen a significant decline in its currency
and has been forced into a corner on payments to the UK and Dutch governments
over the rescue of overseas branches of Icelandic banks.
Without a hint of irony, the Wall Street Journal reported on the Iceland story
barely a few columns away from the Greece story quoted above, on March 4:
Iceland's
leaders are scrambling to blunt the impact of a referendum Saturday in which
voters are set to defeat a measure to repay the UK and the Netherlands for
bailing out depositors in a failed Icelandic Internet bank.
Iceland's prospects for an economic recovery, billions of dollars in
international aid money and its bid for membership in the European Union are at
risk.
Dutch, British and Icelandic officials have been wrangling for nearly a year
over a compensation deal in which the island nation would repay the UK and the
Netherlands a total of 3.9 billion euros ($5.3 billion) for bailing out
depositors in a failed Icelandic Internet bank, Icesave. The failure in 2008 of
all three of Iceland's major banks swamped the country's tiny deposit-insurance
scheme, leaving British and Dutch savers with Icesave accounts high and dry.
The UK and the Netherlands stepped in to pay their own residents' claims. But
they quickly asked Iceland for their money back.
Iceland's parliament approved a deal in December after several false starts.
But in January, citing mass public opposition, the president vetoed it. That
set up Saturday's referendum. A Capacent Gallup survey conducted over the last
weeks of February showed 74% of those who had decided planned to vote "no".
That figure has widened steadily since early January.
This is
an important aside for the markets. In an environment where nation-states can
freely choose to renege on repayments citing their sovereignty considerations,
where do the people providing marginal capital at risk go for insuring their
risks?
In other words, if Greece later on chooses to renege on its austerity pledges,
or choose to exit the eurozone altogether (the currency union, not the economic
free-trade area), where will the buyers of the 5 billion euros of debt today go
to reduce their losses?
The only plausible answer is the CDS market. That makes it more useful to
global bond investors than the European governments calling for its ban.
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