Believe those who are seeking the truth. Doubt those who find it. Andre Gide


Wednesday, October 26, 2011

What Happens If Europe Crushes the Swap Market?

An interesting piece here by John Carney: What Happens if Europe Crushes the Swap Market?

An excerpt:

Many European politicians probably wouldn't mind killing the CDS market. From their point of view, the CDS market has been an unmitigated evil, allowing speculators to profit from the debt burdens of Europe's peoples. Even worse, because the bond market appears to react to widening credit spreads by pushing down the value of sovereign bonds, it appears to make government borrowing more expensive.

Some of Europe's leaders believe the CDS market is manipulated by hedge funds.
But the European leaders misunderstand the CDS market and its relationship to the bond market. The CDS market serves two important purposes: It's both a hedge for investors and an indicator of how risky the market thinks certain bonds are. Many investors are able to buy more of a country's bonds because they can reduce their risk by purchasing swaps that pay off in a default. And the price of the swaps is an indicator—albeit not always a reliable one—of the riskiness of the underlying bonds. In short, the CDS market provides liquidity and transparency to the bond market.

Take away that liquidity and transparency and governments will likely find that lenders are less likely to extend credit. With fewer opportunities to hedge, and prices based on less information, fewer investors will be willing to buy. That would mean selling bonds that have already been issued and staying out of new issues, which would ultimately push up the cost of government borrowing.

17 comments:

  1. I love articles like this. First, we don't need CDS as a risk indicator. Bond spreads already provide that information. As for hedging, unfortunately usage has gone way beyond that. I can't speak to the sovereign market, but in the world of corporates the CDS sometimes become the tail wagging the corporate bond dog. Finally, and most important, proponents never factor in the potential cost of these things. If something goes badly wrong and a major counterparty fails, the tax payer ends up paying the costs that were hidden away in this activity. JC

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  2. JC, good point about bond spreads. I am curious, however. How does one judge whether "usage has gone way beyond hedging?" How do we know this? And if this is indeed the case, how can we tell whether such usage is bad? Just wondering...

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  3. Where is the evidence that CDS have negative externalities? How do you know that bond spreads are a better "risk indicator"? How do you hedge portfolios of corporate or sovereign bonds when there is no active repo market?

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  4. Anon 2:07 is a little short-sighted.

    Bond spreads do contain default risk information but they contain a lot more: expected inflation, an inflation risk premium, a bond liquidity premium, a real risk premium, and other stuff.

    There are lots of reasons why bond spreads change and the probability of default is only one. In contrast, CDS rates are a much cleaner measure of explicit default premia.

    David is correct about the reasons that the CDS market is great.

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  5. PS: If CDS were traded on exchanges -- the way that lots of people, including Ben Bernanke, have advocated -- it would be much more difficult socialize the losses.

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  6. Chris:

    IF CDS were traded on exchanges.

    Why are so many derivative products not traded on exchanges? Is it because they are non-standardized? What would be the implications of forcing non-standardized products to trade on centralized exchanges instead of OTC? Would that necessarily be a good idea?

    Just a few questions I am pondering at the moment. Feel free to help me out.

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  7. "Why are so many derivative products not traded on exchanges? Is it because they are non-standardized? What would be the implications of forcing non-standardized products to trade on centralized exchanges instead of OTC? Would that necessarily be a good idea?"

    Good question. The real question is: Why don't exchanges start contracts in these things? I guess b/c they don't see a demand for them. Why not? I dunno.

    A lot of apparently sensible products -- e.g., inflation futures -- seem to have failed on exchanges.

    We know why CDS are traded OTC, b/c banks find it profitable to do so. And banks like the heterogeneity b/c it keeps them from being a commodity.

    But it seems to me that regulators/Congress could and should force the issue. There is an externality involved. Socialized losses. TBTF. Systemic risk.

    Are there details that I don't understand? Almost certainly. But my inclination -- when someone makes me Chris-the-monarch -- would be to force as many derivatives as possible to exchanges and have more regulation of things like reserves for the remaining OTC products.

    Would that constitute a "tax" on the financial system? Yes. But it is necessary to keep their grubby mitts out of my pockets.

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  8. Chris,

    Individual insurance policies can be highly idiosyncratic. Why can I not pay for my morning coffee by peeling off a slice of my life insurance policy? (Why are idiosyncratic insurance policies illiquid?)

    There may be fundamental reasons underlying the illiquidity of assets, and "forcing" them to trade on exchanges is not likely to make them more liquid.

    And as for grubby mitts in your pocket, can you be more explicit? What sort of transfers do you imagine have been made to the bad guys (whoever they are) over the last few years? (I am being sincere here...pls list off amounts.)

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  9. "And as for grubby mitts in your pocket, can you be more explicit? What sort of transfers do you imagine have been made to the bad guys (whoever they are) over the last few years?"

    How much did AIG's creditors pull out of our pockets to pay for the CDS obligations that AIG wrote? I don't have the number but I think that it is certainly in the tens of billions.

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  10. Chris,

    As of Jan 2010, the CBO estimated the AIG bailout to be $9B.

    http://www.washingtonpost.com/wp-dyn/content/article/2010/01/29/AR2010012904233.html

    As of today, I'm that that the number is smaller than that. I would not be surprised if, at the end of the day, the AIG "bailout" costs the American taxpayer close to nothing.

    Contrast this with Fannie and Freddie.

    So, not really sure why your knickers are all tied up in a knot over CDS.

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  11. "Why are so many derivative products not traded on exchanges?"

    inertia on the part of customers, vested interests work to prevent business moving from OTC to exchange, regulations (e.g. the turf wars between the SEC and CFTC are currently preventing progress in this area)

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  12. Anon: Can you be a bit more explicit in identifying these alleged vested interests and the exact nature of these alleged turf wars?

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  13. "So, not really sure why your knickers are all tied up in a knot over CDS."

    The initial number on AIG was $85 billion, I believe. If it is less now, good. I haven't been keeping up.

    But I still don't want them taking $9 billion from taxpayers.

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  14. So it boils down to the fact that you don't like government bailouts. Fine. But this has nothing to do with CDS per se.

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  15. "Anon: Can you be a bit more explicit in identifying these alleged vested interests and the exact nature of these alleged turf wars?

    the banks have an interest in earning the vig. they do not want products to appear on exchange that threaten that and so will refuse to support certain products.

    turf wars - the SEC and the CFTC fight for jurisdiction over certain products (e.g. certain exchange-cleared CDS) which slows down or prevents their move onto an exchange, or simply results in the exchanges limiting americans' access to the products.

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  16. I think that the Euro will probably collapse and then followed by the collapse of the dollar. These swaps are just a temporary hold up until the inevitable. They need too much money to survive and this is just not enough for them to fully recover.

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  17. I think all markets are manipulated by the bankers. I don't know if the Euro will survive. I just wonder how much longer we have before the global collapse.

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