CDS demonization watch, Morgenson/Münchau edition

By Felix Salmon
March 2, 2010
nonsense on credit default swaps and the like is that they read newspapers, and believe what they read. Two different high-profile newspaper columnists confused Greek credit swaps in 2010 with Greek currency swaps in 2001, for instance, on Sunday alone, and I'm not sure which was worse, although I'll give the prize this time to the FT.

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Maybe the reason that politicians spout such nonsense on credit default swaps (CDS) and the like is that they read newspapers, and believe what they read. Two different high-profile newspaper columnists confused Greek credit swaps in 2010 with Greek currency swaps in 2001, for instance, on Sunday alone, and I’m not sure which was worse, although I’ll give the prize this time to the FT.

First, though, the New York Times (NYT), where Gretchen Morgenson devoted an entire column to the evils of CDS, but threw in this confusing paragraph near the top of the piece:

First, Greece employed swaps to mask its true debt picture, with the help of Wall Street bankers, of course. And now it appears that some traders are using swaps to bet that Greece won’t be able to meet its debt payments and will face a possible default.

This is, I think, deliberately misleading to the point of being downright mendacious — especially since she spent the previous paragraph talking about CDS as “such swaps” and “these swaps”. There is simply no way that the average reader of the NYT can be expected to understand that the swaps of Morgenson’s first sentence, above, are entirely different animals to the swaps of her second sentence, and in fact aren’t CDS at all.

And Morgenson doesn’t stop there. She mangles OCC numbers to make CDS revenues seem higher than they are, and follows that up by describing Martin Mayer as “prescient” for writing this:

“In the presence of moral hazard — the likelihood that sloughing the bad loans into a swap will be profitable — the growth of a market for default risks could lead to bank insolvencies.”

Somehow Morgenson manages to declare that this is a “prediction” which has “come true”. But go back to Mayer’s actual article (which Morgenson, of course, neglects to link to), two things are clear. Firstly, he wasn’t predicting bank insolvencies. And secondly, insofar as he was saying that CDS might cause bank insolvencies, he had a very clear transmission mechanism in mind: banks would attempt to diversify their credit portfolios by using CDS to take credit risk from other banks. And as they started selling more and more of their own loans to other banks looking to diversify, they would do less underwriting, and nobody would have the “credit watch”. Eventually, loans could sour en masse, and that could lead to bank insolvencies if the banks had CDS exposure which they thought was diversified but in fact was just badly-underwritten.

Was that “prescient”? Not really: banks simply didn’t use the CDS market to buy loan exposure from each other (there’s a perfectly good interbank loan market for that kind of thing), and they didn’t seek to diversify their credit portfolios by writing credit protection on other banks’ borrowers. Yes, banks did bundle up CDS into supposedly-diversified instruments — synthetic collateralised debt obligations (CDOs) — which they then sold to investors who blew up, but those investors weren’t other banks: very few synthetic CDOs found their way onto banks’ balance sheets. It was the unfunded portion of those CDOs — the risks that banks kept on their own books, and didn’t sell to anybody else — which ultimately proved so incredibly toxic.

And yet we almost expect this kind of thing from Morgenson, which is why I think the worse column, this weekend, was the one in the FT by Wolfgang Münchau, headlined “Time to outlaw naked credit default swaps”:

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

Firstly, Münchau has done exactly the same thing as Morgenson, eliding 2001′s currency swaps with 2010′s CDS. Goldman Sachs, in its derivatives arrangements with Greece, wrote currency swaps, not CDS. And when Bernanke answered a question about CDS on sovereigns, he was not talking about his investigation into Goldman Sachs. Not that you’d guess it from reading Münchau.

But more to the point, Münchau simply asserts at the top of his column that the eurozone is “currently subject to a series of speculative attacks”, without adducing any evidence, and then concludes that the CDS market should essentially be banned. Oh, and he gets CDS very, very wrong:

A typical bundle would be €10m worth of Greek government bonds. To insure against default, the buyer of a CDS pays the seller a premium, whose value is denoted in basis points. Last Thursday, a CDS contract on five-year Greek bonds was quoted at 394 basis points. This means that it costs the buyer €394,000 per year, for five years, to insure against default. If Greece defaults, the buyer gets €10m, or some equivalent. What constitutes default is subject to a complicated legal definition.

“If Greece defaults, the buyer gets €10m, or some equivalent”? Well, yes, but Münchau fails to mention that in order to get that €10 million, you have to give up your bonds. Most CDS are cash-settled, and the amount of money changing hands in the event of default can be a tiny fraction of the face value of the bonds. For instance, when Fannie Mae and Freddie Mac defaulted, the CDS auction ended up at more or less 100 cents on the dollar: people who had bought CDS protection didn’t benefit from it at all.

Münchau doesn’t stop there. Just watch his rhetoric ratchet up:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

I’m going to come out and say that this is simply untrue: I defy Münchau to find me a single “hardened speculator” who thinks that “there is not one social or economic benefit” to a naked CDS purchase. Of course, there are lots of very good fundamental reasons why people might want to buy credit protection on Greece without owning underlying bonds. Maybe you are or will be owed money by an arm of the Greek government. Maybe you have businesses in Greece, and are worried that in the event of a default you won’t be able to repatriate your profits there. Maybe you intend to enter into a contract with a Greek company who you trust and understand, but want to hedge sovereign risk which is out of that company’s control. These are not “purely speculative gambles”, they’re ways of facilitating capital flows into Greece. Yet Münchau dismisses all such arguments without even understanding them:

Another argument I have heard from a lobbyist is that naked CDSs allow investors to hedge more effectively. This is like saying that a bank robbery brings benefits to the robber.

No, Wolfgang, it isn’t like saying that at all. A bank robbery involves theft, and the robber leaves the bank with more money than he started with. When an investor buys credit protection, that’s a negative-carry trade: the investor leaves the trade with less money than he started with, and only makes a profit in the event that the underlying credit blows up, or in the event that he takes off his trade, and thereby loses his credit protection, after CDS spreads widen.

But of course Münchau isn’t trying to put together a solid argument here: he’s just trying to fan the flames of anti-banker sentiment, perhaps in the hope that they will help to obscure the real fiscal problems in the eurozone which are ultimately responsible for Greece’s current situation. He should remember that when a house is on fire, the first thing to do is to put out the flames. There will be lots of time later to start asking questions about who stood to benefit from the blaze.

(HT: Sanghvi)

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