So I am reading this rather horrific article about the dire financial straits that Greece is in. I had been reading similar articles in the past few weeks at Americablog.
Warning: extremely dry and impermeable discussion of financial instruments to follow. Coffee should be nearby.
Greece is causing the financial markets great consternation of late as the country is on the precipice of a financial meltdown similar to the one the United States just had but perhaps much worse. The NYT article that Americablog links to gives a little more detail, but not much.
Governments raise money in several ways. The simplest is to get it from taxes. However if a government is spending more than it is earning it can either print more money or borrow it. If the country uses the former, it devalues the currency and even though the country just printed more of it, because there is more of it, as a whole it is all worth less. So countries prefer to borrow it. But they have to pay it back...with interest. Apparently, Greece cannot borrow money any more, and credit default swaps are the problem.
Of course the people selling the credit default swaps say it is not their fault and the people buying the credit default swaps say it is not a crime to insure their investments, right?
I suppose it is not their fault. Sort of the way that the cost of energy went through the roof by an order of magnitude in one summer in California wasn't the fault of the energy traders who traded the right to buy electricity dozens of times between ethereal buyers before it got into California. See they didn't actually trade the electricity itself, just the right to buy it at a certain price. And if it seemed like a lot of buyers wanted that same packet of electrons, the price of the packet went way up.
See if you have a commodity and you allow traders to trade with no restrictions they will think of a way to trade your grandmother. Then they will bet on how long she lives and insure themselves in case she dies sooner than they bet she would live. They make money whether she lives or dies but even if she lives or dies, they make money on both ends because they get the taxpayers to bail them out on the side of the bet they lost. Nice work if you can get it.
It starts with removing the restrictions that kept banks separate from investment houses. With all that money they had so many more investments to make and package and sell. But those silly middle class schmos wanted some kind of proof that what they were buying was safe. And all those pension funds with all those pensions belonging to those middle class schmos need some reassurance from bond rating agencies that the crap they were buying wasn't crap.
So why would a bond rating agency want to make a pile of crap not look like a pile of crap? Money of course. Why do you take businessmen out to fancy lunches and give them box seats at baseball games. To get their business. There was a lot of money to be made rating bonds, or whatever you want to call the piles of crap the investment houses were peddling.
So that is how you fool some of the people all of the time and all of the people some of the time. So what do the people that you don't fool all of the time do when they figure out that you sold them a pile of crap? Some of them sell it again. But others hedge their bets and buy insurance, only they don't call it insurance because if they did, it would require that they keep a certain amount reserves of cash on hand to cover paying on those policies. Insurance companies are required to keep reserves on hand because of pesky regulations. But if they don't sell insurance, they don't need to have reserves. Sort of like calling torture enhanced interrogation. Slight digression. The term enhanced interrogation was not dreamed up inside Dick Cheney's twisted mind, though it could have been. It is translated from German, but I won't go any father lest I violate Godwins Law. So you just change the name and give thanks to George Orwell. So you sell lots of insurance and you never have to pay (with your own money) because you have incorporated in several warm climates and your former president is now the Secretary of the Treasury.
Insurance companies sell credit default swaps to insure people who bought the piles of crap or loaned money to Greece for instance. But don't call it insurance. But if you loaned money to a country you got a bond in return, you really bought something after all. A bond that was rated by a lapdog bond agency. So now you start to wonder if the bond you bought was not worth what they said it was worth, so you buy a CDS to insure you in case the debtor defaults. So the analogy wasn't that bad. It is like buying an insurance policy on your neighbor's house but only if you allow parties that have not bought bonds from a country to buy a CDS on those bonds. Otherwise there is no problem with insuring your own purchase. It is problematic for the agency that brokered the deal to sell the bonds to offer to buy those same CDS'.
It is more like a car company like toyota selling cars and then buying insurance on the lives of the drivers because there may be problems with sudden acceleration. It is bad enough to insure against, but not bad enough to warn the purchaser of the commodity. That's deception.
In any case, is it a bad thing for there to be an open marketplace for Credit Default Swaps. Clearly, having it open means more people know about it and thus there is the distinct possibility that a perception arises that the trading of CDS is rampant when it may in fact be already happening, just behind closed doors. But then, in the financial world perception can sometimes drive reality. If customers of a bank think the bank will fail there may be a run on the bank. So even if the bank was not going to fail, the run on the bank, driven by the perception that it might fail, does in fact make the bank fail.
So you have this vicious cycle whereby purchasers of the Credit Default Swaps do so to hedge their bets that their Greek bonds might fail and may be made whole or partially whole if the bonds do fail. But knowledge of the shaky ground that the bonds are on, whether they are in fact on shaky ground spreads. Trading drives up the price of a CDS for a given amount of Greek bonds and now it costs more to insure those bonds. Does it cost more because it was traded back and forth or because it is a reflection of the weakness of the underlying bonds? The result is that you have people see that the cost of insuring a Greek bond is high and interpret that to mean that the likelihood that the bond will be paid is low and therefore abstain from buying the bond. A large drop in demand for the bond will in turn make it harder for Greece to sell bonds. Purchasers will demand more interest but Greece may be unable to pay that interest and on it goes.
The bond rating agencies, whose purpose, once upon a regulated time, was to rate bonds in order for purchasers to properly evaluate the value, strength, and security of the bond are no longer performing their job. Now they are no better than a company that slaps a "green" label on a consumer product because another company paid them to do it, whether or not the product is actually consumer friendly. So has an open market for CDS trades taken the place of bond rating agencies? If it has, should it? If it should, should you be required to own the bonds you are purchasing insurance for? Maybe it is a better way of estimating the security of a bond. If you believe that a marketability of a commodity is an accurate way of determining the value of a thing then is not the value of a CDS tied to a particular bond, and traded in an open and regulated market, an accurate way of determining the likelihood that the underlying bond will be paid off?
Where it all falls apart for the holders of the CDS' is (and now we go back to the analogy of insuring your neighbor's house), you have insured your neighbor's house. This is assuming that you have not tied up any money in owning your neighbor's house. So assuming a predatory stance where you have no ownership interest in your neighbor's house, there is thus a perverse desire to see it burn down. You may want to entice some paroled arsonists to live in the neighborhood. Great for you. But what if there are lots of holders of CDS' tied to lots of houses throughout the city. What if a fire is started and the houses are all linked (like a car company dying would also drive out of business a brake manufacturer). So now you have a great conflagration and you also end up burning down the the fire department and much of the infrastructure of the city. If there were lots of different offerors of CDS's it might be ok. But since the universe of people with enough money to sell a CDS and pay that CDS off is limited and since many CDS's were sold, and since CDS's require no reserves to pay them off because they are not insurance even though they are, the company that sold the CDS's goes bankrupt. Now your great plan to get rich off the destruction of your neighbor's home is looking rather foolish. There will only be so many times when the head of the treasury in your country was a former boss at the company that holds those CDS's and ensures their payment at 100% of their value.
So should we eradicate Credit Default Swaps because of their inherent ability to be abused, or should we harness them to supplant the role of bond rating agencies?