Financial engineering has been on the ropes lately. After the crisis of 2008, many blame financial engineering (and its complexities) for bringing the global financial system to the brink of collapse. In some cases this criticism is justified; in others it isn't. In the case of credit default swaps (CDSs), it's both.
Few financial tools have been as maligned as CDSs, largely due to their role in the downfall of one-time US insurance giant AIG. CDSs are essentially insurance on debt. Investors owning corporate bonds, government bonds, municipal bonds, mortgage-backed securities, collateralized debt obligations (CDOs), or just about any other debt instrument can often buy CDSs to insure the principal value of that debt. So if a country, corporation, or any other debtor defaults, the seller of a CDS compensates the buyer for the lost principal value. As the risk of a debtor defaulting (and thus an insurance payoff) rises or falls, so too does the value of CDSs tied to the underlying debt.
But a CDS buyer doesn't have to own the underlying debt the CDS insures. Speculators can buy CDSs hoping to sell them at higher prices if the risk of the underlying debt rises or that the contract will pay off if a default occurs. In many cases, speculators play a larger role in the CDS market than hedgers, and the principal value of debt insured by CDS can far exceed the actual amount of debt outstanding.
In AIG's case, the firm had written a substantial number of CDSs on various types of debt. When credit concerns skyrocketed following Lehman Brothers' bankruptcy in September 2008, the cost of insuring all types of debt went through the roof. AIG's credit rating was subsequently downgraded, and counterparties to its CDS contracts demanded more collateral than AIG had available (or could raise quickly)—that's when the government stepped in. So while many blame CDSs for AIG's problems, it was really AIG's own risk management that was at fault.
In other instances, CDSs are a bit more culpable. For example, Bear Stearns—one of the largest independent investment banks in early 2008—was a firm heavily reliant on capital markets for funding and regularly issued short-term debt to finance its balance sheet. By using CDSs, some manipulative investors (who were undoubtedly also short Bear's common stocks and would thus profit from a drop in Bear's stock price) were able to buy up CDSs on Bear's debt, which made purchasing Bear debt seem riskier than it might have otherwise appeared. When investors fled, Bear was unable to roll over short-term debt and was ultimately sold to JP Morgan Chase in a deal brokered by the Fed and Treasury. It's possible Bear's downfall was inevitable, and CDS shenanigans merely accelerated the process. But maybe not—we'll never know.
Today, CDS critics fear speculators are up to those same tricks with Greece. Greek and German officials among others have initiated inquiries in whether speculators are manipulating the CDS market, driving up the cost of insuring Greek debt by buying CDSs, which has in turn contributed to widening spreads between the yields on Greek and safer German bonds. But what the Greek government might call manipulation, others might call uncovering the truth. (Otherwise, known as price discovery—a commonly cited benefit of speculation.) Fact is, Greek finances are a mess and until now Greece has been slow to implement needed austerity measures.
Ultimately, Greece is likely to make good on its debt obligations, one way or another, but buyers of Greek bonds should be compensated for increased risk (relative to safer countries, like Germany) through higher yields. It's possible CDS buyers are contributing to rising Greek borrowing costs, but Greece and Germany holding CDS speculators entirely responsible for Greece's financial woes seems decidedly misplaced.
Rather than cursing the CDS darkness, Germany might do well to light a candle.
Greece's concerns aren't so much whether it can issue new debt to meet its obligations; it's whether they can issue debt at a cost they can afford. After all, just about any risky company or country can sell debt if they offer a high enough yield. But Greece has been reluctant to offer bonds at higher yields, arguing costlier debt will only worsen their fiscal situation. In fact early on, Greece offered far below going market yields—the result was, of course, a dearth of buyers and an unsuccessful auction. (Another such misfire occurred this week—though was less hailed.)
It seems increasingly likely Germany will in one way or another end up on the hook for Greece's debt. Earlier this week, German and IMF officials among others announced they're putting together an aid package should Greece find itself unable to raise needed funds through debt sales. Needless to say, German taxpayers aren't thrilled about the idea of sending their hard-earned euros to support fiscally flaky Greece. But could there be a market-based solution to the problem? If German officials truly believe speculators are driving CDS prices above levels warranted by Greece's fiscal situation, and if Germany is effectively insuring Greece's debt anyway, why not sell supposedly overpriced CDS to the very speculators they're taking aim at? As of this writing, the cost of insuring Greek 10-year bonds is about €360,000 per €10,000,000 of principal value—that's 3.6%, about equal to the spread between German and Greek 10-year debt.
If rising CDS costs do raise borrowing costs for Greece as Greek and German officials assert, Germany selling would drive down the cost of insuring Greece's debt, which might in turn lower the market yield on Greek bonds. Or it might simply provide a cash flow stream the Germans could either use toward an eventual aid package or pass along to Greece to effectively lower their borrowing costs. Not to mention it might achieve Germany's stated goal of deterring speculation in the CDS market, at least for Greek debt.
Even if the Maastricht Treaty—the document that established the European Economic and Monetary Union (EMU)—prohibits such a transaction, it's become clear the Treaty's rules were made to be broken. European countries, including Greece, have made liberal use of derivatives in the past. A number of countries have been in violation of the required debt and deficit limits set forth in the Treaty for most of their inclusion in the EMU. And German officials have indicated they'd support expelling a country from the EMU if its fiscal problems imperiled the entire union—a move many argue is legally forbidden.
In this era of government interventions and bailouts, one possibly solution to a government problem might actually have its roots in free markets.