The oxymoronic decision to force private sector creditors to accept voluntary haircuts on Greek sovereign debt is likely to doom the sovereign credit default swaps (CDS) market. CDS are insurance-like financial contracts that allow investors to buy protection from default risk. The new 50% write down on Greek government debt is tantamount to default, but structured in such a way so as to avoid triggering CDS default payments. This is like watching a house burn down while simultaneously learning that fire is not a risk covered in the homeowner’s insurance policy. Why would anyone rationally decide to throw money away on insurance premiums in the future?
The problem for the euro zone is that the potential “buyer’s strike” will extend not only to CDS protection, but also to sovereign bonds themselves. CDS are used to reduce net exposure to credit risk. If an investor has $100 million of gross exposure to Italian sovereign debt, for example, she can cut her net exposure to $50 million by buying $50 million of notional protection in the CDS market. However, if the investor later discovers that the CDS protection does not work, the only way she can reduce her net exposure to $50 million is by selling $50 million of her Italian government debt portfolio. As the head of the trading desk at a major bank explained:
If there is a 50% haircut and it’s voluntary, then my worry is all my sovereign CDS protection in Europe is useless, and my net exposure [to European sovereigns] is much higher. The next level will be calculating how much actual exposure people have, and how much is hedged out by CDS — the exposures could be much bigger.
When net exposures are recalculated in light of the Greek decision, many investors are likely to find themselves well above their allowable risk limits. The result will be large amounts of forced selling to reduce exposure – precisely the opposite of what the bailout was supposed to accomplish. While risky assets boomed after announcement of the deal, the market value of Italian government bonds fell by 2.5% in the day following the CDS announcement as 10-year borrowing costs increased from 5.87% to a new euro record of 6.02%. The market value of Italian government debt is now down by more than 8% since mid-August. Worse, demand for recently auction bonds was weak, suggesting that investors have little appetite to increase current exposures. The decision to avoid the “default” trigger on the de facto Greek default may prove, in retrospect, to be the event that catalyzed an intensification of the crisis.
Avoid the default trigger has two principal motivations:
(1) The European Central Bank (ECB) feared that an official sovereign default of a euro zone member state could lead to a massive financial crisis as creditors pulled deposits from Portuguese, Spanish, and Italian banks. If a euro in Greece is worth less than a euro in Germany, why would any euro zone depositor leave euro-denominated cash balances in the banks of peripheral member states? An official default would also likely leave the ECB insolvent and raise fundamental questions about the sovereign debt that collateralizes the ECB bank notes (currency).
(2) Officials in the European Union very much wanted to punish “speculators” who bought sovereign CDS without underlying sovereign exposure. The supposed scourge of CDS speculation has been the focus of EU officials since the crisis first erupted in May 2010. A formal Greek default would be seen as rewarding those investors who correctly surmised that the Greek debt load was too large to be serviced by the country’s uncompetitive, over-regulated economy.
The decision to avoid “rewarding” speculators at all costs is the classic case of cutting off the nose to spite the face. In addition to likely contributing to a sovereign bond sell-off, the “speculators” in CDS are generally not “naked” as commonly supposed (“naked” means having CDS insurance with no exposure to the underlying risk), but use the CDS to hedge some other, related exposure. For example, the CFO of an Austrian parts supplier that has a large exposure to a Portuguese manufacturer could rationally hedge accounts receivable risk through CDS protection on Portugal. Yet, because the Austrian supplier does not own any Portuguese debt, it is a “naked short” and this is what’s being deemed “speculation.” More commonly, hedge funds and banks might have broad exposure to a certain countries’ stock market or real estate and buy CDS protection on the country itself in quantities greater than their actual holdings of that country’s debt.
At the same time, it’s clear that if CDS increase the overall risk-bearing capacity of the financial system, policymakers’ concerns are not totally unwarranted. Policy analysts seeking to defend credit default swaps from unfair criticism often erroneously assert that these derivatives do nothing to increase aggregate risk-taking in the financial system. As a technical matter, this is true: swaps are zero-sum so that a dollar earned on one side of the contract is exactly offset by a dollar lost on the other side. But by providing investors and creditors with the ability to adjust credit exposures dynamically, CDS increase the efficiency of hedging. And this increase in efficiency makes investors more willing to add certain securities to their portfolio than they would be in the absence of low-cost, liquid markets for partial risk transfer. In simple terms, if the failure of sovereign CDS makes investors less willing to hold sovereign debt, then the existence of CDS must have, on net, made investors more willing to accept underlying risks associated with owning sovereign debt in the first place.
It is unfortunate that many policymakers tend to take a “ban derivatives first, ask questions later” approach to these complex issues. All securities are derivatives on real economic activity, which makes it nearly impossible to draw the line concerning what financial product is useful and what is merely a tool of speculation. Warren Buffett famously called swaps “financial weapon of mass destruction” in 2002, yet by 2009 Berkshire Hathaway was among the world’s largest CDS protection writers.
Rather than being drawn in to the speculation sideshow, policymakers should focus instead on whether legal regimes prevent the market from functioning efficiently. The 2005 Bankruptcy Act may have accelerated the growth of the CDS market by exempting swaps counterparties from the automatic stay in bankruptcy. Creditors are normally barred from demanding immediate repayment from bankruptcy filers. The stay allows repo and derivatives counterparties to terminate their transactions, take possession of the failed firm’s collateral, and “jump ahead” of even senior secured creditors in the order of payment priority in bankruptcy. This eliminates the normal incentives to monitor the borrowing of troubled companies and permits businesses to become more risky.
So, why are swaps counterparties more deserving of legal protection than senior creditors and employees? Similarly, creditors and counterparties to “too big to fail” institutions need not worry about excessive risk created by financial innovation if their claims will be protected by taxpayers in a crisis (i.e. because they can jump to the head of the creditor line). By addressing these issues, policymakers can improve the stability and resiliency of the financial system without picking winners and losers, or retarding beneficial financial innovation.