The former General Counsel of Long Term Capital Management – it of the late 1990s near global financial meltdown – James Rickards, had a comment in the Financial Times a few days ago (Feb 11, 2010) on the credit default swap market and Greek sovereign debt. Key section:
Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?
When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.
Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.
Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.
This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.
When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.
I have general doubts about this being a complete, or accurate description, of the incentives in the CDS market. In particular, I have two questions about this description of CDSs:
- First, is this a genuinely accurate description of the CDS market? This presents it as being unmoored from the fundamentals, partly on account of the lack of an insurable interest (e.g., Goldman Sachs as an empty creditor at the time of the AIG meltdown) – but also because the parties have a massive agency failure problem in which the costs fall upon the hedge fund investors getting charged fees. But is this really the case? Are the parties on both sides, and the middle, in the CDS market really not checking against each other, quite apart from whether there is an insurable interest or not?
- Second, what is the argument for not requiring an insurable interest in the creation of an insurance market? Liquidity and depth in the market?