Here we go again. Germany, France, Spain, Greece and Portugal are talking about extra regulations on credit default swaps, the insurance-like derivatives that let investors bet on debt problems, accusing the international media of a conspiracy or shouting about “speculators”. Some of the more excitable reports even suggest governments have called in the secret services to keep an eye on the hedge funds, although in typical German fashion Berlin called in its financial regulator, instead.
New regulations are already being mooted, with Jean-Claude Juncker, who chairs the eurozone finance ministers, warning of “torture equipment” ready to be used against speculators. But we’ve been here before. At the height of the banking crisis, short-selling bank equity (and in the US much other equity too) was banned, as short-sellers were blamed for the problem – including by John Mack (head of Morgan Stanley, then the biggest servicer of hedge funds wanting to short) and the Archbishops of York and Canterbury (the Church of England invested in hedge funds).
It is true that aggressive, co-ordinated short selling could create a problem at a bank by damaging confidence, starting a run on its short-term funding. But that could only create a liquidity problem. It turns out, of course, that the short-sellers were shorting precisely because there was already a confidence problem caused by the (correct) belief that the banks had a solvency problem. If there was any co-ordinated shorting – which remains unproven, but is being investigated – that was not the problem.
In Greece, the same argument applies. Is a loss of confidence causing the problem, or is the Greek economy like souvlaki – totally skewered?
A loss of confidence is much harder in a country than a bank: you can’t have a run. But theoretically the price of raising sovereign debt, and so commercial debt, could be pushed up, costing the country more. This is happening – but it isn’t happening because of the “shorting” effect of hedge funds buying CDS protection.
Quite the opposite. Hedge funds are – or at least were – buying CDS protection years before the problems emerged, because they believed the market had too much confidence in Greek debt. Greece is a serial defaulter, had a credit-fuelled bubble created by importing German interest rates, and saved far too little.
On top of that, Adair Turner, chairman of Britain’s Financial Services Authority, on Tuesday pointed out that short selling was not the big deal it is being made out to be. He is no fan of CDS – he has warned several times that some financial instruments are “not socially useful” – but he is also pragmatic, having been happy with the short selling ban on banks.
Here’s what Turner told MPs, according to Reuters:
It is important that even if we look at this issue we don’t overstate it. A fundamental issue that can drive volatility on spreads on Greek bonds is a whole load of long investors not being willing to buy.
I believe the total amount of CDS short positions in the area of Greek problem debt is only 3-4 per cent of outstanding Greek sovereign debt. The biggest driver is confidence levels and actions of long investors.
In other words, pension funds and other “good” investors are shy of buying Greek debt, not surprisingly. So not only is it not bad that hedge funds were shorting Greek debt, they weren’t even driving down its price by doing so. The current bail-out talk is already creating the risk of a short squeeze, bringing in spreads, as the WSJ points out.
None of this is likely to stop eurozone finance ministers blaming nasty foreign Anglo-Saxon casino capitalists for their troubles; some hedge funds closed out their short positions on troubled countries weeks ago because they feared exactly this political intervention (although they are now shorting the euro as a whole instead).
However, there is a genuine debate to be had about whether the use of CDS to take speculative positions, rather than simply to hedge existing positions, should be banned. Taking out insurance on something you do not own (which is akin to a “naked” CDS trade) is banned precisely because it creates the incentive to do what you can to damage the thing insured – in this case Greek debt. Plenty of people have argued CDS should be treated on a par with other forms of insurance, famously including Warren Buffett and most recently James Rickards, the former LTCM general counsel, and FT columnist Wolfgang Münchau.
I tend to the view that the incentive is different to fire insurance, and best controlled through regulation; owners of shares, after all, have an incentive to drive up the price through foul means, which we are quite happy to see controlled through regulation. But perhaps the CDS market cannot be made transparent enough, and liquid enough, to prevent it being used for large-scale manipulation, in which case it should be restricted.
In Greece, though, it does not appear to be manipulation by hedge funds which is causing the wide bond spreads. So finance ministers should address their problems at home, before trying once again to turn speculators into scapegoats.