Investors in Greek sovereign debt, sellers of credit protection on Greek debt or those with long positions financial institutions with large exposure to Greek sovereign debt should be very worried about the anti-speculation noise coming out of Europe.
The threats against “speculators” in credit default swaps are eerily reminiscent of the smears against short sellers that came from the heads of Wall Street firms in 2008. Those smears were evidence that the investment banks were refusing to take seriously the bear cases against them. Much the same seems to be going on with sovereign debt in Europe.
Let’s call this the “Warren Buffett Thesis.” When Buffett was approached about a possible investment in Lehman Brothers, one of the things that turned him off to the idea was that Dick Fuld was complaining about short sellers. Buffett reportedly decided that blaming short sellers was indicative of a failure to admit one’s own problems.
That’s what happening in Europe today. The leaders of Greece, France, Luxembourg, France, and Spain have all demanded investigations into whether speculators are causing bond yield spread to widen by bidding up the price of credit default swaps.
The theory has some basic plausibility.
- When the price of credit protection on a bond increases, bond buyers demand more yield. It’s a rather simple equation. If you have to pay more to hedge against a default, you balance this out by paying less for the bonds.
- On a more complex level, the risk management systems inside financial institutions demand this trade off. They take increasing CDS spreads as an indicator of additional risk, and demand more yield—lower prices on existing bonds and higher interest rates on new issues—to compensate for the additional risk.
- This could, theoretically, be open to manipulation. A cabal of CDS buyers could aggressively bid up the price of credit protection, pushing down the prices of the bonds that they later hoped to buy up for sale at a later time, after the prices had recovered from the artificial panic. Alternatively, they could try to start a run into credit protection, buying up protection when it is cheap and selling those contracts as demand rises.
That is, we think, what the European leaders are talking about when they discuss the role of speculators in the market.
The problem with the speculator thesis is that there’s no evidence for it at all. Germany’s financial regulator looked into the idea, and found that there is not massive speculation in Greek credit default swaps. The net volume of the swaps has not risen since January. In total, there are just $9 billion of known CDS on Greece’s $400 billion of government bonds. That’s up just $1.6 billion from a year ago, when the CDS total stood at $7.4 billion.
The willingness of government officials to adopt the speculator thesis in the face of contrary evidence signals an unwillingness to confront the problems that have created the funding crisis. Investors are right to worry—this is just another version of the willingness of government officials to mask their debt levels with accounting voodoo and then place the target the banks that sold them the swaps.
Let’s put this quite frankly. Greece’s so-called austerity program requires absolutely devastating spending cuts that masses of the Greek population seem unwilling to bear. Putting the cuts in place in the midst of a recession is at least arguably suicidal, both economically and politically. Investors are right to fear that Greece might not be able to carry out its program.
What’s more, Greek Prime Minister George Papandreou has been making statements that reveal a frightening sense of entitlement to the wealth of outsiders. He has said that the markets must be tamed by democracy, which we take to mean that he thinks Greek politicians have some metaphysical right to borrow the world’s wealth at low interest rates. In particular, he seems to share the view of many Greeks that the wealthier European countries—and Germany in particular—just owe Greek money. Which is a very strange attitude for a the country with the world’s highest debt-to-GDP ratio.
The problem with this view is that it cannot self-actuate. The Greeks lack a mechanism to force capital markets to fund them at low rates of interest. All they have is a threat of creating instability if the world does not supply them with cheap credit.
That’s what the leaders of Lehman Brothers had on their side as well. It did not end well. We won’t be surprised if Panandreou winds up at the next Dick Fuld and Greece the world’s first sovereign Lehman Brothers.