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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