Thursday, February 25, 2010

CDS demonization watch, Greece edition

Original posted on Reuters by Felix Salmon:

My CDS Demonization Watch has been on the back burner for a while: I thought that the caravan had moved on. But right now, the most-read story in the NYT business section, getting a lot of attention in the Twittersphere, is this one, headlined “Banks Bet Greece Defaults on Debt They Helped Hide”. It’s gaining a lot of traction: Ben Bernanke said today that he’s looking into the issue of whether the CDS market is enabling some kind of run on the Greek government. I sincerely hope he was just being polite to his Congressional overlords, rather than buying in to this theory.

It’s worth looking at the NYT story in some detail, to see just how little sense it makes.

Bets by some of the same banks that helped Greece shroud its mounting debts may actually now be pushing the nation closer to the brink of financial ruin.

Echoing the kind of trades that nearly toppled the American International Group, the increasingly popular insurance against the risk of a Greek default is making it harder for Athens to raise the money it needs to pay its bills, according to traders and money managers.

The first thing worth noting here is that Greece is not anywhere near the brink of financial ruin. The CDS market is actually very good at showing when a borrower is near financial ruin: when that happens, spreads gap out past 1,000bp to something closer to 2,000bp or even 3,000bp. Greece’s CDS spreads peaked at about 400bp, which is high for an EU country, but is nowhere near distressed levels. Yes, every time the CDS spread rises it gets closer to distress, but that’s just as true — and just as unhelpful — if it goes from 30bp to 40bp.

The second point to note about these opening two paragraphs is the curious presence of AIG. AIG went bust because it wrote insurance; the NYT story is here implying that there’s some relevance to what’s happening with Greece, a reference credit that people are writing insurance on. AIG had to pay out billions of dollars to make good on CDS contracts; Greece has neither bought nor sold any CDS contracts at all. No sooner are the parallels made than they break down.

That doesn’t stop the NYT, however, which then proceeds to wheel out the cliché about CDS being “like buying fire insurance on your neighbor’s house”. The problem is that the analogy just doesn’t work in this case. Much later on in the article, after most people have stopped reading it, we’re told the truth of the matter:

European banks including the Swiss giants Credit Suisse and UBS, France’s Société Générale and BNP Paribas and Deutsche Bank of Germany have been among the heaviest buyers of swaps insurance, according to traders and bankers who asked for anonymity because they were not authorized to comment publicly.

That is because those countries are the most exposed. French banks hold $75.4 billion worth of Greek debt, followed by Swiss institutions, at $64 billion, according to the Bank for International Settlements. German banks’ exposure stands at $43.2 billion.

These banks aren’t buying insurance on someone else’s house, they’re buying insurance on their own house. As the old saying goes, if you owe $75,000 to the bank, you’ve got a problem. If you owe $75 billion to the bank, the bank has a problem. And in this case, the banks are doing their best to deal with that problem and manage their risk proactively.

The question here is whether their ability to do so in the CDS market is exacerbating matters for Greece. The mechanism here is complex, if it exists at all:

As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.

At the very least, this does a large disservice to bond investors. They’re not sheep who are happy to lend to any country unless or until its CDS spreads widen — in fact, at the margin, they’re more likely to lend to a country if they know that they’ll always be able to hedge that position in a liquid CDS market. Now, it’s true that as worries over Greece’s creditworthiness get more intense, Greece’s cost of funds goes up. But there’s a strong case to be made that absent the CDS market, Greece simply couldn’t borrow at all: the existence of the CDS market has made it easier (if more expensive) for Greece to borrow money, not harder.

There is a connection between the CDS market and the cash bond market, thanks to the concept of delta hedging — people who sell credit protection on Greece will often end up selling Greek bonds at some point in order to manage their exposure. But that connection is much more tenuous than the alternative, which is that of banks looking to reduce their Greece exposure all dumping their Greek bonds onto the market at the same time. The result of that kind of operation would be spreads much wider than 400bp.

The weirdest bit of all in the NYT article is the way it places the blame not on people trading Greek CDS, but rather on people trading a more general sovereign CDS index:

Last September, the company, the Markit Group of London, introduced the iTraxx SovX Western Europe index, which is based on such swaps and let traders gamble on Greece shortly before the crisis. Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations.

If you want to gamble on Greece, you can gamble on Greece: gambling on a broader Western Europe index makes little sense. What’s more, insofar as people are trading the iTraxx index, they are very unlikely to delta-hedge in the bond market — they’re just taking positions for a few hours or days, trading in and out. Blaming the iTraxx index for Greece’s problems makes no more sense than blaming the ABX index for the subprime crisis: it’s a symptom, not a cause.

But by far the worst part of the NYT piece is its headline: at no point in the article does it come close to making the case that banks in general, or Goldman Sachs in particular, are betting on a Greek default. At worst, banks are hedging their large exposure to Greece and other PIGS nations using an index they helped to create. But the fact is that Greece’s financing burden — the title of the NYT webpage is “Trades in Greek Debt Add to Country’s Financing Burden” — is entirely its own making. Blaming the banks here makes no sense at all.

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