Why it’s silly to blame CDS for Greece’s woes

By Felix Salmon
March 8, 2010
Rajiv Sethi has a good blog entry taking issue with my view on credit default swaps, which The Money Demand does an equally good job of answering. But Rajiv then asks this question in the comments:

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Rajiv Sethi has a good blog entry taking issue with my view on credit default swaps, which The Money Demand does an equally good job of answering. But Rajiv then asks this question in the comments:

A firm can live with a fall in stock price that is driven by purchases of naked puts as long as it’s cost of borrowing is not much affected. If there were some objective probability of Greek default, independent of its cost of borrowing, then CDS spreads would be nothing more than lead indicators of this probability. But I’m concerned about multiple equilibria here: the possibility that there may be more than one default probability that, if believed and acted upon, would be self-fulfilling. I wish Salmon would at least consider this possibility.

Rajiv is absolutely right, in principle, that there can be multiple equilibria when it comes to credit spreads: a company or country can find it easy to repay debt when spreads are low, thereby justifying the low spreads, while finding it hard to repay debt when spreads are high, justifying the high spreads. So the question arises: is there any reason to believe that the existence of a CDS market makes it more likely for credit spreads to jump from low to high? And is that what just happened with Greece?

I think the answer to the first question is no, but I’ll admit that’s a gut feeling: I haven’t seen any empirical research on the matter either way. But even if it has happened sometimes in the world of corporate CDS, I very much doubt that it has happened in the world of sovereign CDS. The reason is that, to a first approximation, corporate defaults are a function of ability to pay, while sovereign defaults are much more a function of willingness to pay.

Exhibit A, here, is Brazil, circa 2002, when the markets were terrified about Lula’s upcoming election, and refused to believe that he would follow market-friendly policies. They drove Brazil’s debt spreads up to 2,000bp over Treasuries — five times the worst levels that we’ve seen in Greece — and refused to lend Brazil any new money at any interest rate at all, at least not in dollars. Brazil was therefore facing a liquidity crisis much worse than anything the Greeks are going through right now: it had essentially no ability to roll over its debts as they came due. A default seemed inevitable, and was certainly more than priced in to the bond markets; while sovereign CDS on Brazil did exist at the time, the market was small and was never blamed for Brazil’s bond spreads.

Eventually, Brazil pushed through, never defaulted, and provided spectacular returns for fund managers who had bought near the lows. If spreads of 2,000bp over Treasuries didn’t turn into a self-fulfilling prophecy in Brazil, I don’t think that spreads of 400bp over Bunds are going to make default any more likely in Greece.

Countries have essentially no limit on how much they can tax or cut spending in order to make their debt repayments: just look at Latvia right now. I’m not saying they should always raise taxes and cut spending rather than default, of course — I’m just saying they can. Companies are in a very different boat, and if they can’t find the money to make a payment then they default: it’s as simple as that.

All of which is to say that if you’re looking for a poster-child of a credit forced into a default by speculative shorting in the CDS market, Greece is pretty much the last place you’d look. For one thing, it hasn’t defaulted, and its spreads are low enough that default is not priced in to its bonds. Indeed, it still has healthy access to the primary market. This is a classic case where Occam’s Razor is entirely appropriate: after Greece revealed that its public finances were much worse than anybody had dared fear, its credit spreads widened, and the CDS spreads naturally widened along with the bond spreads. That’s how debt markets work. There’s no need to posit evil speculators to explain what happened.

(Via Thoma)


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also, Felix, any company/nation that will blow up if it’s unable to roll its debt is not a viable entity at all – it’s a ponzi scheme.

Posted by KidDynamite | Report as abusive


You’re missing Sethi’s point. Almost any heavily indebted company/nation will blow up in a matter of years, if they start having to pay 30% interest rates — because there’s no way for a company or nation to grow out of that kind of debt.

Do you really mean to say that we’re all ponzi schemes?

Posted by csissoko | Report as abusive

Equilibrium error creeps into the baseline premise the moment you start comparing countries and companies without sufficiently contrasting basic nature and interests of these two entirely different species.

In contemporary terms, one will ruin the other without compunction. The other one’s a country.

Too bad it doesn’t function as often in reverse.

If Brazil’s the model of positive outcomes, things have indeed come to a sorry state. Ask millions of unhappy Brazilians how it feels to inhabit a slave colony working to pay off sovereign IOUs, in a permanent state of Lent. It’s a blooming disaster.

Come in, Fotherington-Thomas. Let’s hear you say, “Thanks, WTO! Thanks, retinue of speculators!” in Portuguese. How about in Greek? Russian? Creole? The list, which by the way includes English, goes on…

And please, let’s not quibble about speculators being called “evil” – in various impacted nations throughout the world, white-collar weasels who give speculation a bad name “just following bankers’ orders” are more likely to be seen as as agents of The Apocalypse. Evil is as evil does, after all.

Maybe, just maybe, there’s a sovereign in the world who’ll stand up and stop the rot. Doesn’t look like it’s gonna be the United States, though, does it?

Posted by HBC | Report as abusive

Felix, you might be right about Greece, but your claim that countries “have essentially no limit on how much they can tax or cut spending in order to make their debt repayments” cannot be correct in general. While governments can change expenditure policies and tax rates, they do not have direct control over revenues or actual expenditures, which will depend on the level of economic activity. If attempts to raise revenues are too contractionary, the deficit may increase rather than decrease in the near term. There is also political viability to consider: a government has to stay in power if it is to do anything at all.

Posted by rajivsethi | Report as abusive

csissoko: absolutely. we are all ponzi schemes. the good news (kinda) is that most sovereigns can print their way out of they problems when the pyramid collapses. Greece, as part of the EU, cannot.

Posted by KidDynamite | Report as abusive

Salmon’s reporting on Greek CDSs has been mediocre at best, and we should expect more for someone of his caliber. He has provided thorough and rich analysis of the market behavior of CDSs; for this there is hardly anyone better. But as for a look ‘under-the-hood’? Nada.

What about counterparties? Nothing. Who are they? Zilch. Are they good for it, and is there anyone backstopping them if they can’t pay? (A cricket chirps softly in the background.)

Posted by DanHess | Report as abusive

Made a lot of money back in 2002 on the Lula scare, buying the bonds of non-Brazilian companies that had Brazilian operations, that would not fail even if the Brazilian ops were expropriated. FleetBoston/Santander gapped out, we bought as much as we could, and spreads crashed in quickly after the election.

Would we have made more buying the Brazil government bonds? Yes, much, much more. But the downside of a default was too much to consider — we preferred a safer strategy where we would win with much higher probability.

Posted by DavidMerkel | Report as abusive