Felix Salmon

Why Greece shouldn’t worry about its CDS

Felix Salmon
Feb 23, 2010 20:42 UTC

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.


Yeah, good call. Soros is an idiot, and that’s one of the dumber comments I’ve read in a while. Comparing a CDS contract to shorting a stock is stupid.

And I’m not even sure Soros is saying what you think he is–i.e., that your risk decreases when you’re wrong about a long CDS position because that’ means you’ve lost money, and thus have less to lose. I can’t really think of what else he may be talking about here, but that’s kind of a dumb statement. The thing is, there’s a greater probability you will lose, which of course is offset by the decline in price. So net to zero. If Soros thinks otherwise, then he should be throwing down billions on this blatant mispricing. And another thing, does this mean your risk increases when you are right, because the CDS contract goes up in value and you know have more to lose?

Posted by stevenstevo | Report as abusive

The UK government and vulture funds

Felix Salmon
Feb 23, 2010 17:44 UTC

The UK government has finally published — in the waning days of the Brown government — its take on vulture funds, and whether there should be legislation trying to ban their activities. It’s not clear whether the report has the backing of the Conservatives, but it is clear that a lot of good-faith hard work has gone into it, and that it’s not in any way a knee-jerk piece of populist financier-bashing, a la Maxine Waters.

The conclusion of the UK government, after considering submissions which were roughly equally weighted on both sides of the issue, is that legislation is justified, if it’s tightly constrained to include only a very narrowly-defined set of existing loans to a small group of highly-indebted poor countries. In that case, goes the argument, there’s little risk that the legislation will later be expanded to include a wider set of debts. What’s more, the report explicitly states that “it remains the Government’s view that it would be detrimental to both international development and financial markets to attempt to extend this legislation to countries that are not part of the HIPC Initiative”.

The obvious question, of course, is then why it’s not detrimental to international development and financial markets to implement this kind of legislation at all. Already it’s been stripped of any narrow applicability to vulture funds: it now applies to all creditors of HIPC countries, even commercial creditors who extended trade credit. Under the proposed law, all of them would effectively be bailed in to any debt-relief scheme that the Paris Club and other rich nations agreed upon.

The report calculates the benefit of the legislation at just £145 million, down from an initial estimate of £254 million. For that relatively modest benefit, the UK government seems willing to fundamentally undermine a large number of contractual and property rights, by unilaterally rewriting the law under which loans were agreed. I can’t help but wonder whether it might not be cheaper and easier for all concerned if the UK simply put £145 million into a kitty and made it available to any HIPC countries which ended up having to pay out large sums of money to litigious creditors in UK courts.

One of the worrying aspects of the report is that it seems designed to please no one: the two camps are far apart, and either want no legislation at all or want legislation covering not only a few past HIPC debts but also a large number of other developing-country debts, both sovereign and corporate, and both present and future. As a result, those voting in favor of such a bill are likely to be equally keen to support a much more far-reaching bill, and if this bill passes then that would make the passage of a stronger bill in future that much more likely.

The UK government doesn’t see it that way:

The Government, however, recognises that there will always remain at least a theoretical possibility of such legislation being introduced with respect to future debts by a future government. The perception of such a risk could arise irrespective of this proposed legislation. The Government remains of the view that it is unlikely that lenders will assess the increase in that risk resulting from the legislation proposed to be significant enough to affect the availability or terms of lending to low income countries.

This I think is clearly false. Up until now, the status of UK law as the governing law for many global financial contracts has meant that no government has wanted to interfere with those well-understood mechanisms in such a fundamental manner as this. If such interference ever happens once, the likelihood of it happening again surely rises substantially. At the very least, there would be a move in new lending from London-law contracts to New York-law contracts, which certainly counts as a change in the terms of lending to low-income countries.

So while this report is undoubtedly sensible and sober by the standards of most vulture-bashing, I still think that the possible benefits of its recommendations are tiny compared to its possible costs. And I take some solace in the fact that a new government is likely to come in to power in the UK, which probably won’t make this kind of legislation a priority in the foreseeable future.


The report states:

Against this background, a commercial creditor that successfully litigates and recoups the full value of its debt does so only by free-riding on the relief provided by others, including the great majority of commercial creditors. Legislation is an effective solution to this problem if the benefits of eliminating this free-riding on the component of the debt claim that represents an economic rent rather than the underlying asset value outweighs the cost of interfering with property rights. The Impact Assessment, while unable to quantify the net impact, sets out reasons for expecting benefits to exceed costs for legislation restricted to prevention of recovery of the economic rent component. Legislation that prevented this would help bring about a full, fair and necessary resolution of HIPCs’ debts whilst protecting the rights of all creditors to recover the economic value of their claims. The welcome provision of HIPC-comparable relief by the majority of commercial creditors would not be affected; instead legislation would help to ensure that the proportion of creditors that currently go against this approach would be prevented from doing so.


This is erroneous in that commercial creditors marked their paper down long before bilateral Paris Club creditors who were paid far more in interest than their original principal on the debt they wrote off in the HIPC program.

It is also gobbledy gook. It admits that really the sponsors of the legislation have no real idea of what its impact will be, either on the HIPC countries concerned or the UK itself. This is because it is impossible to precisely define. But it does not even consider the risks. If cost of funds for HIPC countries move even by 25 basis points, the estimated savings are blown away.

It is an admission that the motive for this legislation is political and that the authors really have no idea what the economic impact on the HIPC countries and the UK will be. Pre-election cocktail anyone?

At a time when the probity of the economic data of EU issuers is very mush in the news, it is surprising to see one of its largest debtors supporting such legislation.

Posted by MichaelSheehan | Report as abusive

The systemic risk of the repo system

Felix Salmon
Feb 23, 2010 13:39 UTC

Tyler Cowen has a copy of Gary Gorton’s new paper, and likes it. The excerpt he gives us raises a serious point about fragilities in the banking system: banks fund themselves in the repo market so much that they need about $12 trillion of collateral just to keep ticking over. So if you implement a 20% haircut on repos, banks would need to raise $2 trillion, which is impossible.

The first thing to note here is that no one is proposing a 20% haircut on repos. There’s a school of thought which says that the Miller-Moore amendment does that, but it doesn’t. And in any case, the Miller-Moore amendment only comes into effect after a bank has failed — it’s entirely a question of who takes the associated losses, and has nothing to do with the amount of capital that banks need to hold against their repo-funding operations.

More generally, Gorton suggests that banks’ reliance on the repo market constitutes a systemic fragility which renders the entire banking system prone to runs: “Gorton predicts the crisis was not a one-off event and it could happen again”, writes Cowen. I suspect this is true, but I also hope that Gorton doesn’t go on to advocate some kind of government backstop of the repo market. He wanted the government to start insuring securitizations in an earlier paper, and that was a very bad idea; regulating and insuring the repo market would be equally misguided.

The real underlying problem here is the treacherous state of denial in which the bond market generally finds itself 99% of the time. Participants in the repo markets know that there are risks there, but they ignore them, because ignoring the risks creates a smooth funding mechanism and allows credit to flow much more easily. Then, when there’s a credit panic and everybody becomes alive to the risks, everything grinds to a chaotic halt.

When the government started insuring deposits, it did so to protect both to protect depositors and to protect banks from runs: if depositors are insured, they don’t engage in runs on banks. Nowadays, as banks have moved away from deposits and towards repos as a funding source, deposit insurance still protects depositors; it just doesn’t prevent bank runs as well as it used to. And yes, that’s a systemic risk, which any systemic-risk regulator needs to be alive to. Whether anything can be done about it, on the other hand, is another question entirely.

Update: Gorton’s paper can be found here.


Ask Gary Gorton about his company car from AIG Financial Products, then ask him what Warren Buffett means when he says beware of geeks with models, then ask Joe Cassano what he thinks of Gary Gorton.

Posted by kodiak | Report as abusive


Felix Salmon
Feb 23, 2010 05:02 UTC

On Warren Buffett’s Olympic-grade ex post rationalizations — Jeff Matthews

Porchetta wins today — Grub St

A basic rule of thumb: never invest with a hedge-fund manager based in Florida — Jalopnik (although actually he was based in Atlanta)

Michael Hanley, A GM Autoworker, Commutes 1,000 Miles To Keep Job — HuffPo

Lehman bankruptcy fees: $642 million — 24/7

Maxwell Kennerly weighs in on Cablevision vs JP Morgan — Litigation & Trial

Cutest ever 3rd-grader hatemail — PBS

Cub reporters in Korea drink a lot, “on the theory that plying sources with drinks will be part of their routine” — LAT

Goldman belittles Greece’s billions

Felix Salmon
Feb 22, 2010 21:57 UTC

Memo to Lucas van Praag and the rest of the Goldman Sachs communications machine: you are broadly considered to be out of touch, living large on Planet Billions while the rest of us struggle in one of the harshest economic environments of the post-war era. You might want do something about that. Characterizing €2.367 billion as being “a rather small” amount of money is not going to help.

The fact is that €2.367 billion is a rather large amount of money — both in absolute terms and in terms of a percentage of GDP. Your adjectives just make you look out-of-touch, both in your official press release, where you describe the sum as “just 1.6%” of Greece’s GDP, and in your statement to the UK parliament that it was “a rather small but nevertheless not insignificant reduction” in official debt figures.

Translating into American, remember, 1.6% of GDP is about $227 billion — more than the cost of bailing out AIG, Bear Stearns, GM, and Chrysler combined. And depending on how you account for them, you might even be able to throw Fannie and Freddie in there as well. There’s no such thing as “just” 1.6% of GDP — especially when you’re magically making those billions disappear through clever manipulation of currency swaps.

Speaking as someone who came to your defense in this case, today’s statements make me feel much less inclined to push that case any further: they look as though you’re trying, unsubtly, to downplay the severity of what Greece did here. That’s not a good idea, not in an era when full transparency is the greatest possible good. If this is how you’re attempting to “re-burnish the image of Goldman“, you might want to start questioning the advice you’re getting.


It’s only money and there’ll always be apologists defending Goldman’s right to do whatever necessary to earn more of it no matter the cost. The financial beast will consume us all soon enough. http://theendisalwaysnear.blogspot.com/2 010/02/whos-afraid-of-big-bad-wolf.html

Posted by nahummer | Report as abusive

Jed Rakoff, iconoclastic littérateur

Felix Salmon
Feb 22, 2010 21:24 UTC

Are you still working your way through that 10,600-word Paul Krugman profile in the New Yorker? If you haven’t finished it yet, I strongly suggest you give up — you’re not going to learn much, beyond the names of his cats — and go read Jed Rakoff’s ruling in SEC vs Bank of America instead. It’s much more trenchant, much better written, and much more interesting.

Jonathan Stempel has a few of the Rakoff zingers, including the bit where he calls his acceptance of the SEC deal “half-baked justice at best”, but there’s much more where that came from: I’m particularly fond of the bit where he says that “the relevant decision-makers… appear never to have considered at all the impact that the accelerated payment of over $3.6 billion in bonuses might have on a company that was verging on financial ruin”. And the very end, where “this court, while shaking its head, grants the SEC’s motion”.

But it really is worth reading the whole thing, especially in the light of Rakoff’s ruling against JP Morgan in the Cablevision case, and the fact that Rakoff seems ill-disposed towards the SEC in the Galleon case as well. This crisis has thrown up very few heroes; Rakoff is one of them. Long may he continue to assail both America’s largest banks and the regulators who are captured by them.


Let’s see, no claw back of the bonuses, no penalties for the wrongdoers, and the fine to be paid by the victims. How does this qualify as justice, in any way shape or form?

Posted by dlr | Report as abusive

Investment banking fee datapoint of the day

Felix Salmon
Feb 22, 2010 15:06 UTC

The outcome of this suit — if it’s ever made public — is going to be very interesting. JP Morgan advised Consolidated Minerals when it received a series of takeover offers: as the adviser to the target company, it was pretty much guaranteed a fee, no matter who ended up buying the company. The question is just how much of a fee it was going to get.

ConsMin reckons that it agreed to a cap of A$7 million on JP Morgan’s fees in a 2006 telephone call; JP Morgan, meanwhile, submitted an invoice for A$50.8 million, and claims that in fact it’s due as much as A$86.9 million for its 14 months’ work on the deal, thanks in part to racking up new fees every time a new bid appeared. I’m sure it’s happy it doesn’t have Jed Rakoff trying the case.

(Via McKibben)


The graphic is very suggestive and doesn’t need any supplemental info. Believe the predictions are real in this case. We will see what the future will provide us.

Posted by rcaieftin | Report as abusive

The new world of credit cards: Still treacherous

Felix Salmon
Feb 22, 2010 14:25 UTC

Barbara Kiviat asks whether credit card companies “might be getting their groove back”, and cites this chart:


But, as Eric Dash reports, it turns out that there’s an interesting change of composition hidden in that final uptick:

While most major card lenders sharply cut back on direct mail last year, almost nine out of 10 new card offers were attached to a rewards program that appeals to big spenders, according to Synovate, a global marketing research firm. Only six in 10 applications were for a rewards card program in 2007, before the financial crisis struck.

Now that the CARD Act has come into force, the amount of money that credit-card companies can extract from the sweat box of delinquency has dropped sharply, and they’re looking for more revenue sources. Cards carrying a high annual fee are one such source, since, well, they carry a high annual fee. But they also come with another, more hidden, income stream:

Retailers pay about 2.1 percent of the transaction value on a purchase made by a high-end rewards cardholder, compared to around 1.47 percent for an ordinary customer, according to Visa data.

I’ve never quite understood why and how interchange fees can be so much larger on rewards cards and business cards than on any other credit card. But the card companies are clearly drawing a bad on the fact that they are higher, and doing everything in their power to push rewards cards, even as they weaken the rewards which come with them:

Chase, for example, has overhauled its once generous Freedom rewards card no fewer than three times in the last three years.

In 2006, cardholders were offered a 1 percent rebate in cash or points on all purchases, and 3 percent on items bought at grocery stores, gas stations and fast-food restaurants. By last year, Chase’s Freedom program was far more restrictive. Cardholders had to register online to be eligible to receive the 3 percent rebates — and they were available only in three categories that rotated each quarter.

In other words, the CARD Act might have passed, but the terrain here is still treacherous for both consumers and retailers. Maybe, eventually, we can have a Consumer Financial Protection Agency which helps to rein in some of the excesses. For the time being, though, the banks will chase every loophole they can find.


I am upset that American Express didn’t send me any notice with charge my late fee, which I thought I have already set up the auto pay. I called in and asked the representative set that up for me, but NOT! There is also interest fee charge.
I am going to cancel American Express and will never use it again!!!!!!!!!!!!!!!!!!

Posted by Kammy_MO | Report as abusive


Felix Salmon
Feb 22, 2010 08:25 UTC

Wajahat Ali vs Wells Fargo: An astonishing loan-mod tale — McSweeney’s

Marion Maneker raises questions about the legality of breaking up & selling the Polaroid photo collection — Art Market Monitor

Jay McInerney to replace Becher & Gaiter as WSJ wine columnist. Expect lots of rich-people wines — Dr Vino

Asked if the president can “order a village” to be exterminated, Yoo answers, “Sure.” pg. 70, PDF — NYT

The Best Way to Enjoy Wine: Try Overpaying — Smart Money

Zero tolerance vs common sense — William Polley

Paulson sorry he blamed UK for Lehman failure — Times

“It is a little hard to find a place for Mr. Greenspan in my homes. He is still there, but in a closet” — WSJ

Citi Warns of Withdrawal Gate — Future of Capitalism

A Charlie Munger parable — Slate


I agree with both TinyTim1 and WVJoe, but if the description of the original loan application process is correct, what we have here is not simple fraud by the borrower. It is conspiracy to commit fraud involving the borrower and (at the least) the broker, who (again based on the description) knew that the income on the forms was false but said to sign anyway. I say “at the least” because who knows how far up the chain the knowledge extended.

Posted by KenInIL | Report as abusive