Why Greece shouldn’t worry about its CDS

February 23, 2010
George Soros has wheeled out this particular argument against credit default swaps:

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This isn’t the first time that George Soros has wheeled out this particular argument against credit default swaps:

The situation is aggravated by the market in credit default swaps, which is biased in favor of those who speculate on failure. Being long CDS, the risk automatically declines if they are wrong. This is the exact opposite of short-selling in equity markets, where being wrong means that the risk automatically increases.

It’s worth explaining this in a bit more detail. If you short a stock, the amount of money you can lose is theoretically unlimited. It costs you little or nothing up front, but as the losses move against you, not only do you start getting hit by margin calls, but also the realistic total downside is increasing at the same time.

For instance, let’s say you short a stock at $100, and you know that there’s a 20% chance that the stock will rise by 20%, reaching $120 per share. When that happens, you’ve lost $20 — but now there’s a 20% chance that the stock will rise by another 20%, to $144. And if it gets there, there’s a good chance that it will continue to keep on rising. No matter how high the stock goes, your downside — the amount of money you can realistically expect to lose — continues to grow.

On the other hand, let’s say you spend $100 to insure $1,000 of bonds against default — without owning the underlying bonds. And let’s say that the price of the bonds rise, and their yield falls, as worries about their creditworthiness dissipate. Then the CDS you just bought for $100 might now be worth just $80: again, you’ve lost $20. But now your downside is smaller than it used to be: in the absolute worst-case scenario, you can only lose $80, while initially the worst-case scenario was that you could lose $100.

Financial professionals like Soros tend to mark their positions to market daily — if the market moves against them, then they consider themselves to have lost money, even if they don’t exit the position. And Soros is quite right that when they do decide to hold on to their position, a short stock position which has moved against you looks riskier than a long-protection CDS position which has moved against you.

But buying CDS protection is not really equivalent to shorting a stock — it’s much closer to buying a put option on a stock. And if you do that, your risk diminishes as the market moves against you, just like it does with CDS: you can never lose more money than you initially spent on entering the position. But it’s entirely commonplace for investors to short stocks by buying puts rather than by borrowing and selling securities. Similarly, there is a developed repo market in bonds, so anybody who wants to short a bond the old-fashioned way, by borrowing it and selling it, is welcome to do so. In that case, the risk profile falls somewhere in the middle: there is a limit to how much a bond can rise in price, since the yield will never fall much below zero, and the price is very unlikely to exceed the total value of all principal and coupon payments.

Ultimately, Soros’s argument here is pretty weak. Every CDS contract has a buyer and a seller, and in general it’s the seller of protection who ends up making money: the buyer of protection is often just hedging an existing position, and not looking to profit on the short leg of the trade. Buying credit default swaps is quite an expensive thing to do, and it’s hard to make money at it except for in times of chaos or crisis. If the market in CDS was really biased in favor of those who buy protection, then credit default swaps would be an asset class in their own right, and people would buy bundles of them in the hope of making money. But that doesn’t happen — and Greece, for one, has many bigger problems on its hands to worry about what might be going on in the market for Greek CDS.


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