Lies and truth on sovereign CDS
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”.