Sunday, March 7, 2010

Felix Salmon: Your Dyed-in-the-Wool Credit Default Swaps Enthusiast

Every smart guy has to have a blind spot.

Felix Salmon -- whom I usually find myself nodding vigorously in agreement with -- is an ardent credit default swaps supporter. In a recent post, he uses Greece's recent successful bond sale as a way to trot out his favorite hobbyhorse. Why did the 10-year issue go off so well? Wait for it ... credit default swaps! His take:
A liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil.
The commenters below his short post are understandably angry and baffled, as Salmon doesn't quite explain how the CDS market played savior to beleaguered Greece. So I'll take a stab here: (1) Greece was beset by uncertainty and turmoil. (2) There wasn't enough trading in its existing bonds to give potential investors confidence about what the "correct" credit-risk spread should be for the bonds it was selling, thus threatening to push up yields demanded on the debt. (3) Enter the more active, or liquid, CDS market to save the day -- it stood in as a gauge of credit risk. (Geeky bond talk: offered rates on bonds comprise expectations of future interest rates + inflation along with credit risk; a credit-default swap is pure credit risk, and so isolates that piece of the puzzle for investors wondering what rate they should require on hardly-risk-free Greek debt.)

First, to back up the truck for a second: credit default swaps are reaching the point where they are sometimes unfairly demonized. For example, some European leaders had started to beat up on CDS speculators, saying they were driving up the cost for Greece to issue debt.

Ummm ... don't think so.

Check out Citigroup's rebuttal in this paper: You Can't Blame the Mirror for Your Ugly Face. It happens to be an apt metaphor. Sure, it was becoming more expensive to insure Greek debt against default. But that wasn't because of mischievous hedge funds scheming in smoke-filled rooms; it was because Greece was dithering and making mousy squeaking noises about taming its out-of-control budget deficit.

So let's concede the demonizing-is-occurring-sometimes point up front.

But I think Salmon all too often misses the forest for the trees on credit default swaps. He extols them for supplying liquidity, and that has informational value for the larger bond market and contributes to efficiency in pricing. But, at least in my reading of him, he doesn't step back and look at the big picture. Namely, if financial bust-and-boom cycles are inevitable (and yes, they are), then it behooves us to look at what exacerbates and ameliorates them. And there is good evidence, from this last crisis, that a huge CDS market (that's now shrunk to $25 trillion notional from $50 to $60 trillion), changes a garden-variety financial crisis to a financial crisis on steroids.

Think of what happens in a financial crisis: credit tends to freeze or contract, making liquidity scarce. Now think of what happens right at the same time in the CDS market: there's a large hoovering up of liquidity. You have CDS writers scrambling to post collateral or make good on their bets on the debt of failed companies. They need money and tap available cash and sell assets, just when the economy needs more liquidity. Credit swaps are cyclical enhancers, in a bad way.

And there's more: default swaps are highly leveraged and become highly volatile in times of economic distress. So a CDS on Bank of America trades at 80 basis points, nice and steady, for four or five years, then boom -- all of a sudden Bank of America takes a huge writedown and the swap is zooming back and forth between 600 and 900 basis points. Multiply this by a handful of companies -- you can be assured in a downturn that others will be revealed to be on thin ice -- and now you've got large amounts of money sloshing back and forth, even before a default has been declared, as swap writers try to meet collateral obligations.

All this volatility is not what the distressed financial system needs at this time, but that's what swaps contribute. As they add to systemic volatility, they can feedback-loop in an unpleasant way -- the posters of collateral, if they are not well hedged, can begin adding strains of their own in unexpected places.

And then, because our modern financial system is so interconnected, at some point the very interlaced network of swap sellers and buyers will expose a weak point. AIG was a big weak point last time -- and it was engaged in an undeniably stupid activity. But next time there will be another weak point, probably more subtle. We're not dumb enough, hopefully, to let another AIG write swap protection ad nauseum until the house burns down. But when the markets grow more volatile, and money is shifting back and forth to cover the multi-trillion-dollar exposures on credit default swaps, you can bet that there will be a weak point again -- it could be a hedge fund, a small one that goes down, that leads to cascading failures and, at some point, another giant bailout.

So all that -- the macro, systemic stuff -- is what I'm surprised Salmon doesn't spend more time thinking about because he's a really smart guy.

The suggestion right now is to put credit default swaps on exchanges for trading, to increase transparency and make exchanges the backstop for failure (and who backstops the exchanges? Three guesses and one hint: it rhymes with "shmaxpayers.") It may be worth trying that. But I think we also should look hard at the alternative: even though credit swaps do some micro-good for the market (pricing efficiency on little-traded bonds) they may do too much macro-bad to be allowed to exist.