If a nation is insolvent and no one knows about it, will it still default?
The implication of arguments in an article in today’s New York Times (“Banks Bet Greece Defaults on Debt They Helped Hide”) appears to be that the answer is no. The idea seems to be that because investors can use credit default swaps to insure against insolvency and learn from the price of that insurance what the market’s perception of default risk is, that default itself becomes more likely: “As banks and others rush into these swaps, the cost of insuring Greece’s debt rises. Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow. That, in turn, adds to the anxiety — and the whole thing starts over again.”
The key word here is anxiety, because the CDSs themselves can’t cause a default – they’re not an obligation of Greece. It’s the information they reveal about the riskiness of Greek debt that’s the issue – as the price of CDS insurance goes up, investors know the market believes the probability of insolvency has increased.
As the title of the ‘Times piece indicates, banks and the Greek government have been under fire for supposedly concealing the extent of Greek debt and thus hiding form the world the odds of Greek default. Now financial institutions are simultaneously being slammed for doing exactly the opposite: revealing to the public the riskiness of Greek bonds through the pricing of insurance against their default. That’s a bit too much hypocrisy for one financial crisis.
Indeed, if one were to blame the information revealed by CDS pricing for the sell-off of Greek debt, one might as well also blame the credit rating agencies for threatening to downgrade that nation’s debt rating, which has had the same effect. Aren’t these the same folks we were criticizing a few months ago for not ringing alarm bells fast enough?
The truth is much of the extent of Athens’ debt has been known for years, so when recession hit the market questioned Greece’s ability to pay. As the Greek economy has slowed, banks and other investors quite reasonably concluded that a county whose national deficit exceeds a staggering 13% of GDP (more than four times the EU limit!) is spending far beyond it’s means, with insufficient productivity, national income and tax revenues to cover it’s vast social spending. This is why the EU has also shied away from committing to a bailout of Greece; and, after all, many other European nations have similarly unsustainable spending and debt levels relative to national income.
If governments are ever to get their fiscal houses in order, they must not be allowed to obfuscate their irresponsible actions by pointing fingers at those who lent them money, insured against their failure or simply informed the world of the chance of default. If we allow them to confuse the issue in this way we do them, and ourselves, a great disservice.
Addendum: In a spot-on piece, Shannon D. Harrington of Bloomberg points out that “Greece Credit Swaps ‘Cabal’ May Be Just Sideshow”, arguing that credit default swaps spreads were more an “canary in a coal mine” as opposed to a cause of the crisis, and that “The credit-default swaps traders being blamed by German and French leaders for fueling fears of sovereign debt crises would be doing so with less than 1 percent of the governments’ outstanding debt being wagered…In Greece, where the heaviest complaints about credit-swaps trading have been leveled, bets of $9 billion compare with $267 billion of debt.”
I’d go even further, noting that the ability of the notional value of bets on the occurrence of a credit event to actually change the odds of the event is itself at least questionable. Even if the notional amount were on the same order as the debt itself this may simply reflect the borrower’s precarious position as opposed to influencing it. Some argue the CDS amount (and price) dissuade potential lenders, but even if investors couldn’t bet on a default it hardly implies they wouldn’t learn about the risk by other means much less turn around and lend to a risky credit. To the contrary, the fact that they can lay off that risk in a CDS or similar hedge may be the only reason they’d even consider additional lending.