Streetwise Professor

March 2, 2010

Blindfold? Cigarette?

Filed under: Derivatives,Economics,Financial crisis,Politics — The Professor @ 4:31 pm

The Greek crisis (or, more generally, the EuroSov crisis) is leading to increasingly shrill calls to line up short sellers–and especially “naked” CDS buyers–against the wall for summary execution.  Among the shrillest is this piece by Wolfgang Munchau (sorry about the missing umlauts):

I generally do not like to propose bans. But I cannot understand why we are still allowing the trade in credit default swaps without ownership of the underlying securities. Especially in the eurozone, currently subject to a series of speculative attacks, a generalised ban on so-called naked CDSs should be a no-brainer.

Naked CDSs are the instrument of choice for those who take large bets against European governments, most recently in Greece. Ben Bernanke, the chairman of the Federal Reserve, said last week that the Fed was investigating “a number of questions relating to Goldman Sachs and other companies in their derivatives arrangements with Greece”. Using CDSs to destabilise a government was “counter-productive”, he said. Unfortunately, it is legal.

I only have time for a few comments.

  • Like Wretched Gretchen Morgenson (whom I adamantly will not link to, not wanting to corrupt impressionable minds), Munchau lumps together CDS and other kinds of derivatives, namely currency and interest rate swaps that oh-so-pure European governments used to conceal their debts.  Is he ignorant?  Is he duplicitous?  Does it matter? It is incorrect, and it is misleading.
  • He trots out the tired “CDS are insurance-insurance law prohibits buying insurance without insurable interest-so we should ban naked CDS purchases” argument.  Beware misleading analogies.  Try to understand the particular reasons why, in general, an insurable interest is required to by life insurance on, say, Wolfgang Munchau or fire insurance on his dwelling.  Moral hazard, for instance: Wolfgang’s life and home could be in some jeopardy if this were allowed.  Of course, resources could be devoted to investigate anything untoward that happened to Mr. Munchau, thereby deterring such abuse, but this is costly, and it is difficult to see any social benefit at all from permitting others to bet on Mr. Munchau’s longevity or the reliability of the wiring in his home.
  • Which brings us to Mr. Munchau’s most important point: that there is NO social benefit associated with naked CDS.   He says:

    It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.

  • Not a single social benefit?  All speculators agree on this?  That’s a pretty strong assertion, which is just that: an assertion, offered with little argument and less evidence.  I agree that it is unlikely that the social benefits and social costs of speculation do not align with the private benefits and private costs.  For instance, a good deal of speculation is rent seeking activity, where individuals expend resources to collect information which they trade on in order to receive a transfer from some less-informed sucker.  But that’s different from saying that speculation has no benefit whatsoever.
  • In particular, the information that is embedded in prices by informed speculators can lead market participants to make better decisions, or more timely ones.  This was no part of the speculators’ intentions, but it is a benefit of speculation nonetheless. To the extent that speculation leads to a speedier, and more credible, revelation of the wasteful profligacy of spendthrift governments (or banks, or corporates), the sooner and more effectively this waste can be curbed.  For instance, if you think corporate fraud is wasteful (think Enron), you should also think that short sellers that detect it and profit from it and lead to its ultimate revelation are providing a valuable social benefit.
  • Again, there’s no clean alignment between the individual incentives of speculators and the benefits of their activities, but that’s quite a different thing from saying that there is no benefit at all.  And as Mr. Munchau’s article demonstrates, there’s a real choice involved since it’s impossible to quantify the costs and benefits of any particular speculative trade: you either ban it or let it go (with, perhaps, rules against purely opportunistic activity, such as spreading false information to enhance the value of a speculative position).
  • Mr. Munchau has absolutely no data on how much CDS purchasing is naked.

Muchau’s outrage is shared by virtually every government in Europe.  Spare me.  This is clearly shooting the messenger.  As James Carville noted long ago, the bond market (and now, the CDS market), disciplines governments, and they don’t like it one bit.

This article from Bloomberg hits the nail squarely:

Blaming derivatives for governments’ financial problems is like faulting the “mirror for your ugly face,” according to analysts at Citigroup Inc.

. . . .

“We would do better to spend our time addressing the defects the mirror shows than blaming the mirror,” Citigroup analysts led by Michael Hampden-Turner in London wrote in a note to investors. “After all, banning mirrors does nothing at all to make the world a prettier place.”

Damn right.  Nobody likes market discipline, especially governments.  But they’re the ones who usually need it the most.  Hence we should resist cynical, self-interested calls to terminate CDS speculators, and instead pay more attention to the message they are sending about the unsustainability of fiscal policies in Europe, and around the world.

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