The leaders of Germany, France, and Greece have all come out now to blame Greece’s (and the euro’s) troubles on speculation in credit-default swaps. Picturesquely, the Greeks say that a CDS is an insurance policy purchased by an arsonist on the house he intends to torch.
Looked at from the investor’s point of view, a CDS is what adds liquidity to the asset that gets created when he lends money to build the house. The house doesn’t get burned down by the guy who lent the money to build it. It burns down when the people who live in it smoke in bed. This whole story is a smoke [sic] screen to keep the Greeks from getting blamed for running budget deficits four times higher than eurozone rules allow, and then lying to cover that up.
But is there a larger issue here? What happens if we restrict the use of CDS?
Think of the practical difference between stocks and bonds. Most people have an expectation of liquidity in stocks (and in things like bank deposits). Liquidity means you can buy or sell an instrument, in size, on short notice, without significantly moving the market.
All else equal, a liquid asset is more attractive to own than an illiquid one, and accordingly priced somewhat higher. To see why, imagine that your bank allowed you to write checks only two days out of each month, effectively converting your checking deposits to time deposits. You’d demand that the bank pay you interest on the deposits. Time deposits have a lower value (reflected in the cost of the interest you demand) because they’re less liquid.
Stocks on publicly-traded companies are generally very liquid, at least in the block sizes traded by retail investors, because there’s an active secondary market for them. This adds to their value.
Bonds have *never* had this kind of liquidity (except for on-the-run Treasury debt). If you buy a corporate bond, no matter what kind of investor you are, you’ve traditionally done so in the expectation that you’d hold the bond until maturity. If that was a long time (say, 30 years, or 100 years for French railway bonds, or forever for British consols), then you would demand a very high rate of interest to compensate you for everything that go wrong in that time.
The credit-default swap is an instrument that overcomes the illiquidity of fixed-income assets. For the first time in history, it’s possible to buy and sell the credit risk of a note or bond. This makes it possible for more people to own them, and for their owners to be able to realize their value in a much shorter time frame when needed. It also (and this is the problem the Greeks have) makes it possible for people to reduce their exposure to debt if the issuer proves over time that he’s less creditworthy than you thought he was.
Because you can’t easily buy and sell most debt instruments, a CDS gives you an easy way to buy and sell their credit risk, which is a major component of their value. It’s almost as good. And because the CDS in effect makes debt more liquid, *it increases its value and generally reduces the interest rate.* That’s the key point, and that’s what we lose if we give up on the CDS, which is only one of a whole range of recent technical innovations intended to make more investor capital available to more users.
Stock markets have generally been more liquid than bond markets, which is a big reason why they suffer crashes and volatility. (In fact, economists have concluded many times that volatility in stocks partially offsets the value that comes from their higher liquidity. Now that’s some wicked math, if you ever want something to break your brain on.) Bond markets have historically been a lot more stable. When Marilyn Monroe said that “gentlemen prefer blondes,” she was playing on a much older phrase: “gentlemen prefer bonds.”
And the lower liquidity is one reason for the greater stability. Now, with CDS, bond markets can be nearly as liquid as stock markets. That’s why they’re more volatile and prone to unjustified large price swings and crashes. It’s also why countries like Greece, which has no business borrowing large amounts of money, can do so at rates once reserved for disciplined borrowers like Germany.
There are pluses and minuses to severely restricting CDS usage (or at least to requiring they be standardized, as option contracts have been). Let’s recognize that the whole world will pay a lot more for capital if we do. Especially since the basic fiscal policy of the US is to borrow heavily because borrowing is politically cheaper than raising taxes or cutting spending.
There’s nothing that’s more real than credit risk. Let’s say I lend you a dollar in full recognition of the risk that you may not pay me back. I can certainly quantify that risk, and it serves to discount the value of the asset I own, which is nothing more than your promise to pay me a nominal dollar on a future date certain. (Together with whatever interim interest payments we’ve negotiated.)
Standard practice for centuries has been to discount risk in this way. If you’re a borrower without credit risk, like the US govt, I’ll lend you 100 cents to get back 100 cents. If you’re a triple-A corporate credit (of which, if memory serves, there are a grand total of FIVE), then I might lend you 98.5 cents in order to get back 100, plus the interest. If you’re less creditworthy, then I might only lend you 85 cents against your promise to pay me 100 plus interest. And so it goes.
If I have no choice but to stick with you until the note matures, then you and I are married in a fundamental business sense. I might be able to convince a bank to lend me money against your note, but of course they will discount your note more heavily than I did, and they’ll also discount ME and charge interest. That’s a standard way to obtain finance, but still I’m married to you for the duration of your note. Sorry, till your note matures. Duration means something different in bond-land.
But I can measure your credit risk, by a variety of means, many of them subjective. What if you default to someone else on a note just like mine? That’s an obvious one. But what if your boss starts to whisper that times are a little tough, and you should only count on a 4% raise this rather instead of 5%. Do you see how that affects the likelihood that you’ll pay me back on time?
If I can withstand your credit risk for the whole term of the note, fine. But I lose the flexibility to change my mind. If you buy a stock, you have that flexibility because you can choose to sell on a moment’s notice, also based on subjective factors. Being able to trade credit risk isn’t any less real or valuable.
It’s one thing to have this conversation as individuals. But what if I were a public pension fund? I lend you money so I can use your interest payments to pay my retirees every month. Can you see that, if there’s even the slightest risk that you might not pay off, that I can’t even lend you the money in the first place? And if your circumstances change during the term of the note, my retirees are totally exposed. I wouldn’t even consider lending money to anyone who looks anything like you, and in fact it would probably be illegal or counter to my charter to do so.
The availability of a CDS changes all of that. The CDS turns the credit risk of billions of little notes into a large liquid thing that can be traded and moved around. This fact by itself isn’t the problem. The problem is that there is a totality of risk around the world, whether it’s liquid or not, and we don’t have perfect tools for measuring it or even for detecting it all. A properly regulated CDS market might in fact make the financial system MORE stable by making total systemic risk more transparent, something that has never been possible before.
The bottom line question is: how much credit are we willing to have in the world? Most of Wall Street’s rocket science is aimed at squeezing more credit out of the same amount of capital.
It’s very, very clear that we overshot. We created more credit than we should have, in large part because the math we used underpredicted total risk. (Well, it actually underpredicted the incidence of long-tail events.) As I’ve been saying since mid-2007, the world suddenly saw that problem and immediately overcorrected for it. If you recall, from late 2007 until Sept 08, the term we used was “credit crunch,” rather than “economic crisis.” That’s why it was plain to me that major economic weakness was ahead, even as we were having record highs on the stock market and up-5% quarters on GDP.
Governments softened the blow by essentially converting all that private credit to public credit, which is risk-free. So we haven’t fundamentally solved the problem of determining exactly how much credit you can safely create from a given amount of capital, and (what is mathematically far harder) how to plot that optimal credit quantity against time. While the past 20 years have been about running that calculation overconfidently, the next 20 will be about doing so underconfidently. I hope you can see that this is all orthogonal to specific pieces of technology like CDS.
I would argue that, because it’s impossible to predict the timing or severity of long-tail events, there is a proper role for a govt authority in providing a backstop to the system, ASSUMING a more correct distribution of total risk across the timeline. That more or less happened in late 2008, which is why I was immediately in support of TARP and never questioned it for a second. What has happened since then is that we’ve elected a govt that takes a far more expansive view of their proper role, and that’s screwing up everything.
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