In Credit Default Swaps We Trust
by David Atkins
The European debt crisis has been a maddeningly complex story to follow, but the latest development is fairly simple:
After marathon talks, they emerged early Thursday to announce that a new package of measures to rescue the euro currency had been agreed on. The deal entails increasing the firepower of Europe’s bailout fund to about $1.4 trillion, getting holders of Greek debt to take losses of 50%, injecting Europe’s biggest banks with about $150 billion to withstand those losses and providing Athens with an additional $140 billion to stay afloat.
“We have reached an agreement which I believe lets us give a credible and ambitious and overall response to the Greek crisis,” French President Nicolas Sarkozy told reporters, adding that “the results will be a source of huge relief worldwide.”
Or is it? The devil is in the details, specifically regarding credit default swaps (CDS). If you followed the U.S. financial crisis or read your Taibbi or Michael Lewis, you know that credit default swaps are essentially insurance on bonds, be they nation-state treasuries or mortgage-based collateralized debt obligations. Theoretically, they help encourage investment in the same way that having car insurance helps you afford a car: if it the investment wrecks, then the buyer is not at a total loss. The details are much more complex; it doesn’t work precisely like car insurance, but it’s a decent analogy. So what’s the problem with CDS? Well, for starters, an infinite number of people can buy an infinite number of credit default swaps on any given package of loans. In a bubble when the value of everything is going up, this isn’t a problem: the investors make money, their losses are insured for far less than the profit on the investment, and the CDS sellers make big profits.
Of course, when there’s a downturn, look out. That’s what happened in 2008, when the chits got called in on $70 trillion worth of CDS, much of it guaranteed by AIG. If AIG had defaulted, it would have been like an earthquake insurance company defaulting in the event of an earthquake, in a market built on a fault line where no one would have bought property but for the insurance. So the government bailed out AIG, in essence as a way of bailing out the rest of Wall Street. Readers of Taibbi’s Griftopia will recall Goldman Sachs’ particularly vicious, mafia-like tactics in blackmailing AIG and the government to pay what Goldman thought it was owed, even as all the other financial firms were willing to take a haircut to make a deal.
Credit default swaps in their current form are, in fact, a terrible thing for the economy. If they were regulated and limited like most other forms of insurance (e.g., no betting your neighbor’s house will burn down, only one person able to take insurance on a house, and so on metaphorically speaking), they might be beneficial like other forms of insurance. But in their current unregulated form, they’re a disaster. Failure to regulate credit default swaps in even basic ways stands out as by far the biggest failure of the Dodd-Frank regulatory reform, and proof of the inability of Washington to do even the bare minimum to put Wall Street back on a leash.
Why bring up CDS in relation to the Eurozone situation? Because under the current plan, the value of CDS is about to come under major scrutiny, with potentially harmful economic consequences:
Although it’s better than a 100% loss, a 50% haircut is still pretty bad, at least for those who paid face value for Greek bonds. What makes it worse, though, is the characterizing that the loss is voluntary. That appears to prevent holders of the debt from cashing in the credit default swaps they bought as insurance on the bonds.
To the extent that the average person knows anything about credit default swaps, he or she probably thinks they’re exotic and risky financial instruments that amplified the impact of Lehman Bros.’ demise. In fact, they can be a useful tool for hedging risk. And if investors can’t hedge, they’ll be less willing to take chances with their money, restricting the flow of capital. That’s a bad thing for the economy.
Anyway, the EU’s move undermined swaps on sovereign debt, if not more broadly. That has some traders worried about even bigger problems to come as other European countries come under fiscal pressure. Here’s a telling, although unfortunately anonymous, quote from a Reuters piece:
“People talk about Greek CDS triggering being destabilizing, when it’s really the opposite,” said one global credit trading head at a major European bank. “If there is a 50% haircut and it’s voluntary, then my worry is all my sovereign CDS protection in Europe is useless, and my net exposure [to European sovereigns] is much higher. The next level will be calculating how much actual exposure people have, and how much is hedged out by CDS — the exposures could be much bigger.”
Yes, it’s true: the plan to make bondholders eat their risky investment in Greece and thereby weaken the CDS market will almost assuredly hamper corporate investment, particularly in the financial sector. The cost of borrowing may indeed go up, and the value of assets in the bond and stock markets may decline.
But honestly, that is what is supposed to happen. The entire world got caught up in an addiction to cost-free, bubble-fueled asset-based growth. Having a $70 trillion unregulated credit default swap market is an insane idea, no matter how much it helps prop up largely unproductive investment assets in the short term. A financialized economy built on asset growth rather than wage growth is inherently unstable and unsustainable, as I wrote at length last week. It is also guaranteed to dramatically increase income inequality, which is ultimately destabilizing for societies and for democracy itself as global protests have proven.
Insofar as world economies have spent the last 20-30 years pursuing the next fix in financialized asset-based growth (and the Anglosphere has not been alone in doing this), going into rehab is going to be a painful process. Every heroin addict knows that simply injecting more heroin seems a heck of a lot easier in the short term than going through rehab. But if they want their life back, rehab is the only option.
But the advantage of going cold turkey on credit default swaps is that one can come out with a sustainable, equitable financial system on the other side. Those who call for safety net austerity while trying desperately to score another financialized asset-based fix will end up flatlining their economies and their entire social systems as well, just as surely as the druggie who goes without food and medicine to get high will flatline his heart rate.
Despite the concerns, the Eurozone is haltingly doing the right thing here, even as the Anglosphere still pretends it doesn’t have an asset addiction problem.
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