Credit Default Swaps

Ugh.

In today’s Financial Times Gillian Tett, whose writing I otherwise admire, has an article in which she concludes that sovereign credit default swaps have a useful role to play in international finance. She’s been hanging around with her Wall Street buddies too much.

Before your eyes glaze over – alright I admit that’s too late – let me point out that CDS spreads are now popping up everywhere as an early warning sign of impending sovereign debt collapse. The specific example Tett uses is the recent problem the Greeks have had as their debt grows wildly out of control. Apparently the spread on Greek national debt CDS has widened dramatically, and this augurs imminent disaster.

Yawn.

The problem I have with sovereign CDS contracts is not theoretical. In a perfect world, as envisaged by the folks that brought us modern portfolio theory or rational expectations theory both now thoroughly discredited, a CDS plays a very useful role indeed. But find me a perfect world and I will grant you this role.

Recall what a CDS is: it is an insurance policy that someone buys to offset the potential loss incurred in different asset. In the case of a sovereign debt CDS an investor is buying insurance to cover all or part of a loss in value on a particular government bond. Since CDS’s can be traded there exists a spread between the rate earned on that contract and those of other financial contracts. The wider the spread the riskier the underlying asset – e.g. the government bond – is seen as being and the more likely it is that the investor will have to resort to cashing in the insurance policy – i.e. the CDS.

So widening CDS spreads are seen as a portent of trouble in the realm of the underlying asset.

Sovereign CDS’s present an odd case: if spreads widen on them, the information we are meant to glean is that a particular government debt is getting risky. Since the CDS market is only a few years old it is only in the current crisis that we have become aware of this special property of a CDS. The financial media has taken up the cause with glee, and now opines breathlessly on every slight deviation in the sovereign CDS market. This, of course, fits with the ideological bias that the financial media seems to have against deficit spending as a recession fighting weapon. The media can now point to CDS spreads as ‘objective’ confirmation of what we are all supposed to have known: markets are efficient and Keynes was horribly wrong.

Now, you will notice that I mentioned CDS’s are wonderful in a perfect world. This is true. Like all of modern economics the theory that gives credence to a CDS suffers from being utopian nonsense. We don’t live in a perfect world, but please don’t tell the folks in Chicago it will spoil their fun. For the rest of us allow me to point out two salient problems with the notion that sovereign CSDS’s are either useful or credible.

First is the depth of the market. No one has any clue how many CDS contracts are being traded on any given day. This raises the specific issue of ‘price discovery’. One of the magic powers economists ascribe to a market is its ability to allow prices to be ‘discovered’. This discovery is the outcome of a healthy bidding process at the end of which all the market players are said to ‘know’ the value/price of the assets being traded. This magic process can only work as long as there are plenty of bidders. When only one bidder turns up he or she can essentially fix the price at whatever level suits them. The rest of us would have no idea if such a price would hold up under more intense bidding. This is an issue with the CDS market: in some contracts, and possibly in the Greek case, the market appears to be very thin. Consequently the spreads being quoted may reflect the opinion of one or two large hedge funds rather than a healthy market. This invalidates the notion that CDS spreads are a reliable predictor of risk in the relevant underlying asset class.

Second, and more telling, is the fact that most CDS’s are issued by banks. Here I find it gratifying that the European Central bank has adopted my position. I find it extraordinarily perverse that anyone would buy insurance against loss on sovereign debt from a bank whose very existence relies on the continued subsidy and support of that self same issuing government. Think about that in the context of the US. There are people out there buying CDS insurance against the default on its bonds by the US Treasury. Good so far. The problem stems from the fact that the insurance issuer may be Goldman Sachs or, even worse, Citibank, whose ability to pay up on the insurance is only enabled because they have received US Treasury support. The entire logic of the transaction defies reason. The implication being that at some point the investor who purchased the CDS against the US debt is worried that the US will default but that Goldman will still exist to pay up.

There’s a handy profit to be made shorting that investor’s IQ.

Except, of course, that much of the activity in the CDS market seems to derive from lunatic traders selling each other completely useless stuff. In which case a CDS contract on US debt makes perfect sense: no one expects it be be cashed in, but it sure helps add to those volumes we all need to generate to hit our bonus targets.

Things like this are why some people, me included, think that much of what passes for banking nowadays is a charade with no social value whatever.

But: the problem is that until everyone wakes up to the charade the financial media will continue to quote sovereign CDS spreads as if they had real meaning.

It is because of this kind of flimsy and nonsensical rubbish that policy makers sometimes make decisions. I would laugh if people like Tett weren’t actually serious. So far have we travelled from reality in finance that she foresees a valuable role for sovereign CDS’s in the future.

Where’s Lewis Carroll when we need him?