Is speculation on government bonds Credit Default Swaps (CDS) responsible for the crisis on G10 sovereign debt?
In virtue of market efficiency theory, the tenants of a CDS free market assert that CDS give the right signal on the anticipated default probability, hence contribute to informed investment and “optimal” resource allocation.
Actually, the question deserves to be raised since the Credit Default Swap market determines the cost of Governments’ debt. The relationship between credit swap spread and bonds’ spread is explained by the possibility of forming a risk free portfolio by buying (or selling) a protection on the CDS market while buying (or short selling) the cash bond.
The CDS market is similar to a giant football betting platform where the odds change the outcome of the game. Gamblers’ bets on the game Manchester United vs FC Barcelona should not in principle change the game outcome (except if some gambler is able to fake the game…). But in the CDS case, the alleged efficient market modifies the outcome! Indeed, when speculators move the CDS upward by betting on a country’s solvency problem, they provoke a rise in the cash bond’s spread and a rise in the debt cost, as seen above. Let’s visit a very simple example: if Greece is supposed to issue an annual debt equal to 25% of its GDP (refinancing of existing debt plus new deficit) and if at the same time the cost of debt increases by 200 bps, the new debt payment will deteriorate its annual deficit by 0.5% of GDP. Even worse, this credit spread deterioration might trigger a downgrade by major rating agencies such as Moody’s and S&P, which in turn might prompt foreign investors to sell off non compliant Greek bonds.
The problem is even more acute as investors attack countries like herds. The following chart represents the normalized CDS spread of various G10 countries since December 2009, as computed by Riskelia
We can observe that the correlation is almost perfect. It means that once Greece is attacked, the issue moves from Greece to the next countries most exposed (Portugal, Spain, UK…). The problem can never be solved because if Greece is bailed out at a European level, the club of supposedly safe countries (Germany, France) will be attacked in turn provoking a doom loop. Ultimately, only the IMF will have the credibility to bail out the whole system.
We cannot just stand there and let the market kill Governments in the name of supposed market efficiency. What we advocate is very simple: preventing investors from buying CDS protection on Government debt when they don’t hold the corresponding cash debt. This measure would necessarily go with a restriction of sovereign bond shortselling. By contrast, sellers of CDS would not be constrained, since they play an evident social role, allowing Governments to finance their debt.
For sure, these common sense rules won’t prevent countries from failing and must not divert them from curbing their unsustainable debt paths. With or without CDS, the UK and the US, after Greece, Spain and Portugal, will sooner or later be confronted with their public debt problems. Someday foreign investors who hold most of their gigantic debt might decide to dump these newly baptized “toxic assets” from their portfolio, but it is the subject of our next article…