More on speculation: Banks, Credit Default Swaps, and Greece’s Debt
by Linda Beale
More on speculation: Banks, Credit Default Swaps, and Greece’s Debt (Part 2)
Yesterday, I commented on Darrell Duffie’s defense of speculation in the Wall Street Journal, here. I noted that the idea that speculation is a positive because it absorbs risk others don’t want and helps reveal the “true price” by providing more information about the speculated item seems more of a stretch in the midst of this crisis than we might have thought before. Absorption of risk only works if there is a more or less even playing field, with some long and some short, but that adds little to information or price. If there is an abundance of information on price–because traders are shorting the stock or rushing for credit default swaps, then that information will tend to swing the price and make it much more difficult for speculators to absorb the risk, as the market teeters offbalance on that item and pushes the item more and more to the cliff that the speculators have predicted.
Whatever the underlying problem in Greece, financial speculation has been a factor in tilting the balance towards disaster. The price of credit default swaps has gone up, and each time that Greece tries to borrow to pay its debt, it has to pay more and the CDS cost goes up and Greece looks riskier in a vicious cycle threatening illiquidity. Thus, one commentator notes that “credit default swaps give the illusion of safety, but actually increase systemic risk. See Banks Bet Greece Defaults on Debt They Helped Hide, NY Times, Feb 25, 2010.
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crossposted with ataxingmatter
***Whatever the underlying problem in Greece, financial speculation has been a factor in tilting the balance towards disaster.***
Without denying the possibility that could occur, speculation really seems to be innocuous in this case. There is no realistic plan to straighten out Greece’s affairs. The Greeks are having trouble borrowing money because there is a substantial risk they will not pay it back. It’s hard to blame speculation for that.
On the other hand Darrell Duffie’s defense of speculation wasn’t very persuasive, and I pretty much agree with Warren Buffet. If people keep on playing with increasingly complex and baffling financial instruments there is going to be really serious trouble. I don’t actually have any problem with speculation, but how about we build financial sandboxes that are designed to contain the damage? Let speculators bet to their hearts content within the sanbox? Restrict speculation outside sandbox to relatively low risk, low leverage stuff that might reasonably qualify as “value investing” — sales, purchases. covered calls. And if we allow financial insurance (CDSes) call it insurance, regulate it like insurance, and require that the underwriters be able to cover any conceivable sequence of events… or, at least, state clearly what they are not covering.
I think you are on the wrong track when accusing speculation. Everywhere speculation does not exacerbate a problem that it lays bare but actually builds a safety net without which prices would plunge further. As for the banks speculating “against” the same assets they bought that equally isn’t mysterious: it’s like a bank that owns a mortgage and sees the customer (Greece) playing with gasolene – so now it takes out insurance to safeguard against a fire that would destroy its collateral (bonds held in this case). That makes sense AND it drives down the profit, not up!
The price of credit default swaps has gone up, and each time that Greece tries to borrow to pay its debt, it has to pay more and the CDS cost goes up and Greece looks riskier
It’s not the CDS’s fault. If there were no CDS’s, that information would just translate into higher interest rates.
It is Greece’s debt that is the problem here. If you borrow too much you are in trouble. Period.
“Absorption of risk only works if there is a more or less even playing field” — it also requires firebreaks between different sectors of the financial industry so that one segment (e.g., subprime mortgages) plunging into the sewer doesn’t take the whole global economy with it ! Diversification is not just a reason to stick brokerage clients with the investment banks’ toxic securities.
More subjective bullshit. Buying a mutual fund for a 401k is not speculation (I presume). But when Goldman buys a portfolio of assets it is speculation.
Vtcodger: I assume under your system there would be a czar that would magically prevent institutions from trading in both markets. By the end of yoru comment we get to the one word jingoism that solves all problems (according to the Church of Liberalism) “regulate”.
How has the EGH (Efficient Government Hypothesis) holding up for you lately?
As I understand it, the Germans say Wall St. and London are speculating on the Germans to bailout Greece.
Looks like Goldman helped Greece to kook the books to qualify for sub-prime loans from Goldman and Co. which are sold to be insured by Germany. That allows Goldman and Co. to make risk free currency speculations.
In looking at the function of credit default swaps I don’t see how they add systemic risk to the economy. However, I do see how increased systemic risk in the economy could hurt multiple parties in a CDS transacton.
A “credit default swap” (CDS) is a credit derivative contract between two counterparties. The buyer makes periodic payments to the seller, and in return receives a payoff if an underlying financial instrument defaults.[5]
As an example, imagine that an investor buys a CDS from AAA-Bank, where the reference entity is Risky Corp. The investor will make regular payments to AAA-Bank, and if Risky Corp defaults on its debt (i.e., misses a coupon payment or does not repay it), the investor will receive a one-time payment from AAA-Bank, and the CDS contract is terminated. If the investor actually owns Risky Corp debt, the CDS can be thought of as hedging. But investors can also buy CDS contracts referencing Risky Corp debt without actually owning any Risky Corp debt. This may be done for speculative purposes, to bet against the solvency of Risky Corp in a gamble to make money if it fails, or to hedge investments in other companies whose fortunes are expected to be similar to those of Risky. If the reference entity (Risky Corp) defaults, one of two things can happen:
Either the investor delivers a defaulted asset to AAA-Bank for a payment of the par value. This is known as physical settlement. Or AAA-Bank pays the investor the difference between the par value and the market price of a specified debt obligation (even if Risky Corp defaults, there is usually some recovery, i.e., not all your money will be lost.) This is known as cash settlement.
The “spread” of a CDS is the annual amount the protection buyer must pay the protection seller over the length of the contract, expressed as a percentage of the notional amount. For example, if the CDS spread of Risky Corp is 50 basis points, or 0.5% (1 basis point = 0.01%), then an investor buying $10 million worth of protection from AAA-Bank must pay the bank $50,000 per year. These payments continue until either the CDS contract expires or Risky Corp defaults.
All things being equal, at any given time, if the maturity of two credit default swaps is the same, then the CDS associated with a company with a higher CDS spread is considered more likely to default by the market, since a higher fee is being charged to protect against this happening. However, factors such as liquidity and estimated loss given default can affect the comparison.
Credit spread rates and credit ratings of the underlying or reference obligations are considered among money managers to be the best indicators of the likelihood of sellers […]
Who is blaming speculators for the problems in Greece other than socialist Joe Stiglitz.
Once incomplete and imperfect information are introduced, Chicago-school defenders of the market system cannot sustain descriptive claims of the Pareto efficiency of the real world. Thus, Stiglitz’s use of rational-expectations equilibrium assumptions to achieve a more realistic understanding of capitalism than is usual among rational-expectations theorists leads, paradoxically, to the conclusion that capitalism deviates from the model in a way that justifies state action—socialism—as a remedy.
The effect of Stiglitz’s influence is to make economics even more presumptively interventionist than Samuelson preferred. Samuelson treated market failure as the exception to the general rule of efficient markets. But the Greenwald-Stiglitz theorem posits market failure as the norm, establishing “that government could potentially almost always improve upon the market’s resource allocation.” And the Sappington-Stiglitz theorem “establishes that an ideal government could do better running an enterprise itself than it could through privatization”[19] (Stiglitz 1994, 179).
For a genious this guy has some idiotic ideas. Just goes to show that smarts has its limits and foibles.
***So why again did we need to bail out AIG? Maybe AIG’s CDS losses would have caused them to dig into other assets affecting other of their insurance businesses? Anyone know the answer.***
My understanding is that shorn of all the superstructure, a Credit Default Swap is just an insurance policy which is really just a bet wrapped up in a lot of boilerplate. They aren’t called “insurance” because people would want to regulate them like insurance.
I believe the issue with AIG is that they took in huge bets against high default rates on mortgages and neglected to lay the bets off with other bookies. The company — big though it was — could not possibly cover the bets from other assets. It would appear that the government eventually backstopped AIG to the amount of 182 BILLION dollars which is really a LOT of money even by current standards. http://www.marketwatch.com/story/geithner-paulson-defend-182-bln-aig-bailout-2010-01-27
In principle maybe all it would have taken to prevent the AIG thing would have been for the number and terms of all the CDSs to be public knowledge. In principle, once the counterparties could see that AIG was taking bets it couldn’t possibly cover in the event of loss, some/most/all would look for another counterparty/insurer/bookie. I’m skeptical that it is that easy, but I’m wrong sometimes.
Anyway, that’s what I think happened. If someone tells you something different, they might be right.
I am kind of curious about who is taking the long side of these events and who will pay the piper if Greece defaults. And if the interest of the average Greek means anything, that is what Greece should do, as well as dropping out of the Euro. It was only the vainity of the elites that brought Greece, Italy, Spain, and Portugal into the Euro zone.
Reading the Lords of Finance right now, thinking of 1929 and the great bubbles of my own life time, the dot.com market and U.S. Housing bubble, contrary to Scott Summer, it was pretty plain to many people that these bubbles were all driven by irrational speculations, of asset prices rising far above what information on their fundamental values would indicate, with what another luminary of the past called “stupid money” looking for an “sure thing” and ending in a “panic.” I am looking at all the empty houses, and half empty shopping malls here in rural Virginia and I have to say that the Government can certainly screw up some things, but only the market in the thrall of a “popular delusion and the madness of crowds” can create ghost towns like I see dotting the landscape of Florida, California, Arizona, and Neveda.
The bubble are not driven by speculation but by excess capital. Too much money to lend or invest properly. Excess capital will alway fuel rampant speculation. We need to bring back high tax rates for the rich. I never understood why people bought the bullshit that tax cuts to the rich fuel economical growth when historically there is very low correlation between cutting high tax rates and economical growth. The great depression was cause by stock market speculation which was fuel by cut in the tax rate to the rich a few years prior.
I noticed that Alan Reynolds posted a comment to an old main post (2006) today. Not sure why he did it, but note the paper he references.
Here’s the 2006 main post and comment thread:
http://www.angrybearblog.com/2006/06/did-you-say-voodoo-let-me-introduce.html?showComment=1267742080000#comment-c6400207250927831370
And here is the paper he referenced:
Roundtable on budget, taxes and economic growth
http://www.treas.gov/offices/economic-policy/roundtable_2004.shtml
The “Conventional” Hypothesis:
Deficit Estimates, Savings Rates, Twin Deficits and Yield Curves
http://www.treas.gov/offices/economic-policy/round_table_documents/2004/reynolds.pdf
I don’t get where the quote is from.
That is what the derivatives regulation approved by the Agriculture Committee today intends to do–since swaps desks at banks would prevent the availability of the Fed window and force banks to move those desks out.
Speculation isn’t the cause of the root problems in most cases, but it can certainly magnify volatility and increase costs of borrowing for the entity shorted and therefore add to the riskiness of the system. That was the problem with the subprime synthetic CDOs like the Abacus deal Goldman created so that Paulson could go short a selected basket of crummy loans–the gearing in the market created by the synthetics didn’t create the problem but it definitely worsened it,
I think you are very close. AIG apparently at some point bought the kool-aid that housing could only go up. Given the low spread it was charging, it didn’t calculate having to pay out.
I once wrote that CDS were useful tools as indicators of market expectations of default and quality of the referenced obligations, but I am no longer of that opinion. Bet placing is not necessarily informative–it may be, but it may not be. It can also lead to herding instincts. Transparency isn’t there–information about who holds CDS positions and what the valuations are is not readily available (and it is not clear that the bill approved today by the Senate Agriculture committee will be sufficient to make the trades transparent, given the exceptions for a number of trades, including “customized” derivatives). CDS contribute to the “interconnectedness” systemic risk. And a few big trades can create considerable volatility. All in all, the merit of CDS for the financial system is not nearly as strong as it seemed to be just a few years ago.
Greece and Spain won’t pay back. This was a calculated Risk, and a Lesson for the Banking System. The only thing Germans can do is:
REPOSSESS 170 Leopard 2AEX Battle Tanks from Greece, and 190 Leopard 2A6E Battle Tanks from Spain.
U.S.A must REPOSSESS 170 F-16 Jet Fighters from Greece, … the rest is gone with the wind …forever …
Greece must stop paying lucrative pensions with borrowed money, reform the free health care system, and cut down, 4 times the military budged.
Greece’s problem is too much debt. Greece has a budget deficit of 12.7% of GDP – meaning that the country is spending 12.7% more than the value of one year’s economic output.
Greece is no different to a serial credit card borrower who can’t pay back his loans. But just like a serial credit card borrower, as long as Greece keeps relying on borrowed money to fund itself, the problem won’t go away. It will just get worse.
http://www.defenseindustrydaily.com/Greece-in-Default-on-U-214-Submarine-Order-05801/
Don’t worry; the ECB, the Fed or both will print the money.
And all of us will share the pain, with our hard–earned money.
Bad is never good until worse happens.