"Defenders and Demonizers of Credit Default Swaps"

Rajiv Sethi argues that naked credit default swaps can be destabilizing for reasons that defenders of these contracts "would do well to consider":

Defenders and Demonizers of Credit Default Swaps, by Rajiv Sethi: The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps. These contracts can be used to insure bondholders against the risk of default, but when purchased naked (without holding the underlying bonds), they can serve as highly leveraged speculative bets on a rise in the cost of borrowing faced by the sovereign states.

A cogent case for prohibiting the use of credit default swaps to make directional bets has been made recently by Wolfgang Münchau... Felix Salmon objects... Sam Jones also rises in defense of naked CDS contracts...

So the argument here is that while hedge funds may have raised the cost of borrowing for Greece in 2008-09, their current actions are making borrowing easier and less costly. 

Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider. 

Any entity (private or public) that faces a maturity mismatch between its expected revenues and debt obligations anticipates having to to roll over its debt periodically. Such an entity could be solvent (in the sense that the present value of its revenue stream exceeds that of its liabilities) and yet face a run on its liquid assets if investors are sufficiently pessimistic about its ability to refinance its debt. More importantly, it may face a present value reversal if the rate of interest that it must pay to borrow rises too much. In this case expectations of default can become self-fulfilling. 

This is the central insight in Diamond and Dybvig's classic paper on bank runs, and is a key rationale for deposit insurance. William Dudley highlighted the importance of such effects in a speech last November:

If a firm engages in maturity transformation so that its assets mature more slowly than its liabilities, it does not have the option of simply allowing its assets to mature when funding dries up. If the liabilities cannot be rolled over, liquidity buffers will soon be weakened. Maturity transformation means that if funding is not forthcoming, the firm will have to sell assets. Although this is easy if the assets are high-quality and liquid, it is hard if the assets are lower quality. In that case, the forced asset sales are likely to lead to losses, which deplete capital and raise concerns about insolvency.

Dudley is speaking here of financial firms, but his arguments hold also for governments that do not have the capacity to issue fiat money. This is the case for state and local governments in the US, as well as individual countries in the eurozone. In either case, expectations of default can become self-fulfilling even when solvency would not be a concern if expectations were less pessimistic.

What does this have to do with naked credit default swaps? As John Geanakoplos notes in his paper on The Leverage Cycle, such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation.

Whether or not these considerations are relevant in accounting for the troubles faced by Greece is an empirical question. But it does seem to be within the realm of possibility. At least the Chairman of the Federal Reserve appears to think so: 

Addressing concerns that financial firms have been engaging in trades to bet on a Greek default, Bernanke said that "using these instruments in a way that intentionally destabilizes a company or a country is counterproductive, and I'm sure the SEC will be looking into that."

Felix Salmon hopes that Bernanke "was just being polite to his Congressional overlords, rather than buying in to this theory." I hope, instead, that he is taking the theory seriously.

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Update (3/7). Felix Salmon has another post dismantling a New York Times report on the issue. The Times is an easy target, and it is true that their reporting has been riddled with errors and inconsistencies, including a bizarre failure to distinguish between the financial market effects of selling credit default swaps without adequate capital reserves (as AIG did), and the consequences of large scale naked CDS purchases (as hedge funds are alleged to have made).

But what I would like to see from Salmon is a clear distinction between the use of CDS contracts for hedging (which even Münchau would probably agree has beneficial effects on the ease and cost of borrowing) and their use for speculation (which need not). The Sam Jones post does this, and makes clear that if current hedge fund activity is holding down CDS spreads, then prior activity must have had the opposite effect. One may then ask whether Greece (and its fellow PIGS) would be in such a precarious position without this prior activity: this is an empirical question that has yet to be convincingly answered.