Don't Blame Credit Default Swaps for this Greek Tragedy

Felix Salmon savages the New York Times, and Gretchen Morgenstern in particular, for the claim that credit default swaps have somehow been pivotal in the financial crises that have rocked the US and Europe.

In order to believe that CDS are "shaking Europe", you have to believe that when one market player buys sovereign credit protection off another market player, in a transaction both sides think they're going to make money on, finance ministries across the continent start to tremble. It's silly. Sovereign credit spreads have moved up and down in sometimes-dramatic fashion for decades, long before CDS were even invented. And they will continue to do so even if CDS are banned. And there's no indication whatsoever that volatility in European credit spreads is any higher now than it would have been absent the CDS market. Indeed, there's a colorable case that the opposite is true, and that the ability to hedge one's exposure in the CDS market has made the European sovereign bond market less volatile. 

As for the NYT's idea of the "purpose" of a CDS, all I can say is that I have no idea whatsoever where they got that one from. At least on the CDS/Greece connection, you can see how various European politicians love to be able to blame Goldman Sachs rather than themselves for their woes. But this just makes no sense at all. What "complex debt securities", exactly, can banks issue more easily if CDS reduce the risk to purchasers? Presumably we're not talking about simple bonds and loans here, since they're not complex at all. Is the idea that banks somehow help companies issue debt bundled with CDS insurance? I've seen a few monoline wraps in my time, but nothing like that

You see this sort of folk mythology among market watchers very frequently.  They note that there are financial instruments which convey negative information about the soundness of the underlying institution.  Furthermore, they quickly realize that just before institutions fail, there is often quite a lot of activity in those sorts of financial instruments.  Therefore, if you could only eliminate the instruments, you could also eliminate the failures!

Unfortunately, there is always some official around to make the case to gullible journalists that his institution's failure is the result of exotic financial predation, rather than his own mismanagement.  Thus Patrick Byrne has actually managed to convince people who can't read a financial statement that Overstock.com's problem lies with the naked short sellers, rather than the company's continued dismal performance.

But there are almost never people with enough capital to mount a "bear raid" on a company, much less a country.  If the majority of the market thinks the company or country is basically sound, a naked short seller may very temporarily depress the price--but it will quickly be bid back up again by bulls leaping on the aberration.  If it keeps falling, that's because there aren't a lot of optimistic buyers in the market.

In other words, short selling, or credit default swaps, may hasten price discovery--we may find out that people are bearish on the stocks or bonds a little faster than we otherwise would.  But the price would still fall, in the end, because stock buyers will offer lower prices, and bond buyers will demand a higher yield.

But the correlation is so bee-yoo-ti-ful, it's hard to convince anyone of this.  Who are they going to believe:  some stuffy economics paper, or their own lying eyes?

There's no question that credit default swaps can make things worse for the specific firms that get heavily involved in them . . . see American International Group for specifics.  But neither Greece nor the euro-zone got in trouble because Goldman Sachs led them down the primrose path. The trouble started with a garden-variety country that couldn't get its finances under control--and that's where the bulk of the trouble still resides.