Lies and truth on sovereign CDS

By Felix Salmon
March 9, 2010
NYT: now the BBC is printing "explanatory" articles about credit default swaps which are simply wrong. Check out the factbox:

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It’s not just the NYT: now the BBC is printing “explanatory” articles about credit default swaps which are simply wrong. Check out the factbox:

Government bonds come with an insurance policy, called a credit default swap (CDS).

Hedge funds have been buying up vast quantities of CDSs linked to Greek bonds in the hope or belief that Greek government will either default on a bond interest payment, or have its credit rating lowered.

This is because in both cases, the seller of the CDSs – typically banks or insurance firms – would have to pay a penalty fee to the buyer of the CDS contract.

Is there anything here which is actually true? No, bonds don’t “come with” a CDS attached. No, there is no evidence of hedge funds (or anybody else) “buying up vast quantities of CDSs linked to Greek bonds”. No, a downgrade of Greece would not result in the seller of the swap having to pay out on it. And no, a swap payout is not “a penalty fee”.

The important thing here is not the inaccurate reporting so much as it’s the way in which heated political rhetoric has been unquestioningly accepted by journalists who simply don’t have a grounding in this stuff. If a lie can get halfway around the world before the truth has got its boots on, this one has circumnavigated the planet twice while the truth is still slumbering in bed. No one wants to be seen as defending banksters, so even those who should know better are happy to stay complicit in the lies.

That said, I was invited to a media lunch hosted by Loomis Sayles today, and I took the opportunity to ask David Rolley, their international fixed-income guru, whether CDS had been or could be used for nefarious purposes. And he unhesitatingly said yes, on both counts, saying that Brazil, for one, has paid as much as $1 billion in extra funding costs thanks to hedge fund types who use CDS to drive up the country’s bond spreads ahead of new issuance.

Of course, the hedge funds in question are likely long Brazilian debt anyway, so a ban on naked CDS wouldn’t prevent that kind of activity. In fact, they’re trying to get even longer Brazilian debt, and trying to manipulate the price at which they’ll be asked buy it on the primary market. So I wouldn’t necessarily say that they’re trying to destroy the country. They’re just trying to get a bit more out of them, in terms of interest payments.

Still, that kind of activity — front-running new issuance in the CDS market — is undoubtedly a little bit distasteful. I just don’t think that it deserves to be talked about people expressing “the hope or belief that the government will default”.

(HT: Coldwell)


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Wow. So should we credit the New York Times with being slightly less completely wrong? I guess that’s what Krugman meant…

Posted by aristid | Report as abusive

So if the hedgies could use CDS to drive up the spreads on Brazilian bonds to get a better a yield, couldn’t they use them to drive up the yields on Greece so high that it had to default? And presumably there’s a way they could profit by that, if they were sure it would happen?

My question is real, not rhetorical, I don’t pretend to understand these things.

But it seems that the Loomis Sayles guy essentially agrees that CDS can be used to distort the market, which seems to cry out for some kind of regulation, at the least.

Posted by expatsp | Report as abusive

Felix, for goodness sake, stop picking on such easy marks.

Your ignorance in the arcana of CDSs beggars belief, even though you write about CDSs all day long.

You embarrass yourself with every CDS piece you write, not by what you write, but by what you leave out.

If you want to really educate yourself on CDSs, young warrior, you could do worse than starting with some of what Chris Whalen has to say. He is far brighter than I am. nterview-with-chris-whalen-of-institutio nal-risk-analytics.html

Basically, CDS pricing is the essence of everything that is wrong with efficient market theory, which should be dead by now but is alive and thriving.

CDSs are not pricing off of real default risk, but volatility. Oops!

Posted by DanHess | Report as abusive

How do you drive up the yield on a not-yet-issued bond by trading CDS? They are different markets, no? So by what mechanism does this take place? Are we assuming that underwriters and investors look only to the CDS spread when deciding what price to pay for a bond?

Posted by Sandrew | Report as abusive

Yes, could you explain this market manipulation a little more clearly? So far we have:

1. By CDS protection in advance of bond issuance.
2. Buy the bond on issue.
3. ???
4. Profit!

Assuming that I was able to move the market when I bought CDS, I am left with a coupon that pays higher than treasuries … but it’s a fully funded position and I still have counterparty exposure to my PB. What’s so great about that? And if I close out the CDS position and that moves the market back to where it was, sure I’ll have made some money on the bond but I’ll have lost it on the CDS. Where does the free money come from in this trade?

Posted by Greycap | Report as abusive

While the BBC as a whole is pretty decent news organisation (particularly for things like range of foreign affairs coverage), the website is shockingly bad, especially when it comes to technical or specialised subjects such as science or finance. It’s scarcely more reliable than the Daily Mail.

Posted by GingerYellow | Report as abusive