Tuesday, March 2, 2010

The benefits of naked CDS

I think that derivative products… the CDS on sovereign debt have to be at least very, very regulated, rigorously regulated, limited or banned, this is a personal position on financial instruments

- Christine Lagarde, Europe 1 Radio

In his regular column in Monday’s Financial Times, Wolfgang Münchau argued that naked credit default swaps – that is, CDS positions taken by investors who do not the underlying bond to which the contract refers – should be banned.

There is a straightforward logic to this, and Münchau put it clearly and eloquently:

A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

But the logic, while straightforward, is also invidious. And in one significant instance, wrong.

Here’s the rub: there is a palpable social and economic benefit to naked CDS positions. And what’s more, that benefit has perhaps never been more strongly borne out than as in the recent case of Greece.

First, some context via a trip back in time: back to 2004, when the Euro was a more lustrous specie than it is today, and when credit default swaps were breaking into the mainstream.

As they are wont to do, some hedge funds in those more moderate times spotted an opportunity for a trade: a contrarian though commonsensical trade that could be sat on for years. A trade very obviously right but as far as everyone else in the market was concerned, wrong. In short, exactly the kind of hubris-busting trade that hedge funds like.

The trade was very simple. Buy eurozone sovereign CDS.

Specifically: buy default protection against the eurozone’s weakest member states, the bonds of which had no place trading so close to German bunds. Buy Italy, buy Spain, buy Greece. And do so, naturellement, au naturale.

Buying such naked short positions was cheap. Five – count ‘em – basis points a year bought you a 10 year CDS contract on Spain. Twenty for Greece. Ten for Italy.

How though, did the funds involved envisage that this trade would make money?

What they saw happening was an inevitable re-risking of the eurozone. Italy could not possibly be priced so close to Germany indefinitely, and at some point, during the lifetime of their ten year CDS contract, spreads on Italian bonds would widen.

When they did, and those bonds became cheaper, the funds would buy the Italian bonds – matched as closely as possible to their existing CDS contracts’ maturities.

The result would be –- if done well — a perfect sovereign basis trade. And because the CDS contracts required so little initial outlay, it could be done on a huge scale, to significant profit.

Consider a very messy, simplified and hypothetical example:

In 2003, I buy 10 years of CDS protection on Italy for 5bps annually. In 2005, amid sex scandals, a spate of mafia-linked bankruptcies and a dodgy milk company – this is, dear reader, hypothetical – S&P downgrades Italy and says it is a much riskier credit than is implied by the market. Italian bonds drop in value, and their yields rise significantly.

I buy enough bonds to match the protection on them I already own, and then, with zero credit risk left, I pocket the spread.

Alternatively, to the same effect, I become a a writer of CDS protection myself.

—–

In any event, the pan European blowout was six years in the offing. Many of the hedge funds that bought CDS in 2004 gave up the ghost: six years is a long wait for the eurozone to reconnect with economic reality.

In 2008 and 2009 though, the logic of the trade returned with more heft, even if sovereign CDS had long-since risen above their longtime 5-50bps range.

Last year, big hedge funds were significant buyers of CDS protection on risky EU states: in particular, they bought CDS against Greece in anticipation of a budget blowup that would send the yields on Greek bonds soaring at some point in the next few months.

(Among the funds said to have done this: Paulson & Co, the $32bn totemic shorter of the US mortgage market and second biggest hedge fund in the world. Paulson declines to comment on specific positions.)

What, though, to return to the point of this post, of the broader economic and social benefit of all this beyond well-heeled Mayfair and leafy Connecticut?

The point is twofold:

Firstly, any naked CDS buying – as slated by Mr Münchau – occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks. (Banks, stuffed to the gills with sovereign debt thanks to the ECB, have)

Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe (as Mr Münchau notes, Greece seems content to do this all on its own anyway).

Secondly, and more importantly, however, hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

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