Mirror, Mirror, on the Mall

Barron’s – 15/03/10

BEWARE OF GREEKS BEARING BONDS — and Germans and Frenchmen, too. The shrill, closely coordinated campaign launched this month by the three nations to curb speculation on their sovereign debt — and especially short-selling — is a sneaky attempt to subvert markets. They cannot succeed; but in trying to, they could inadvertently injure current holders of European debt, a universe that includes pensions, endowments, and mutual funds. The three nations want mandatory reporting of all derivatives-trading in Europe. In this, they mirror U.S. proposals to regulate the credit-default market by making participants use centralized trade execution and clearing houses and post larger amounts of collateral. These Europeans propose a step further than the U.S., however: Banning naked short selling of sovereign debt on the CDS market. To what end?

The new Greek prime minister, George Papandreou, put it most succinctly in his March 8 address to the Brookings Institution in Washington, a day prior to his meeting with President Obama: « The market is and must be part of the realm of our political decisions, » said the Greek leader.

But make no mistake about it, Papandreou is trying to impose a usury law on the market. Papandreou also said: « We’re not asking for free money. We’re not asking for bailouts. We’re asking for the right to have similar rates of borrowing as other countries. » But ultimately, that could be an even bigger headache for Greece and the European Union than CDS because rates unreflective of economic reality would frighten investors. Papandreou, who spent much of his childhood in California, should count his bond-market blessings. The Golden State has a $20 billion deficit, and recently had to pay buyers of its long-term debt 5.65%, tax-free — the equivalent of an 9.58% taxable yield for someone in the 35% bracket.

Well before Papandreou’s October election, Greek politicians employed CDS to hide debt from the European Central Bank, which otherwise would have commanded it to curb its runaway spending. Credit-default swaps, or CDS, which, in essence, are elaborate insurance policies, caused the blow-up of financial giant American International Group (ticker: AIG) in September 2008. American taxpayers pumped an estimated $70 billion (of $180 billion set aside) into AIG to prevent its collapse as well as serious collateral damage to some of AIG’s swap co-parties — like Goldman Sachs (GS) and French, English and German banks. CDS aren’t traded in an organized or transparent manner on any big exchanges. Transactions almost exclusively are « over the counter, » between two or more big investors like banks and hedge funds and pensions.

Many of the documents describing the trades are phone-book thick and legally dense. The back offices of many firms where the trades were recorded could not keep up with the traders. In fact, they fell so far behind that no one had any idea how great were various firms’ or nations’ exposure to various risks. CDS are often used to hedge bond positions. If I’m long Greek bonds, I certainly want to insure myself against loss or default if the country’s recently adopted 650-million-euro austerity plan (US$900 million) proves unworkable, because if such an event were to transpire, then spreads on the debt would widen, driving down the market value of my position. I would buy the insurance from a counterparty who believes the risk is minimal, and so agrees to pay me if the country devolves into chaos. In an unhedged, or naked short sale, if I were to own Greek bonds and were convinced that civil unrest like last week’s street riots would cow lawmakers into abandoning the fiscal restraints adopted earlier in March, then to capitalize on my belief, I would find someone who’s equally sure the restraints will hold and is willing to write me a policy.

Papandreou’s government must borrow €54 billion this year. According to the Wall Street Journal, Athens had anticipated paying an average rate on the bonds of 4.7%. However, Greece this month had to pay 6.25% when it issued €5 billion worth of 10-year bonds. If Greece paid this on all its new debt, it would incur interests costs of €700 million — which would exceed the austerity measures’ total by €50 million. At Brookings, Papandreou blamed short sellers spreading malicious rumors for driving up the rates on Greek bonds. « Unprincipled speculators are making billions every day by betting on a Greek default, » he charged. Shut them down, he says, and those rates would decline.

IN FACT, RATES COULD CLIMB even higher. « Shoot the messenger, and you remove valuable [pricing] information from the market, » says Richard Metcalfe, head of global policy for the International Swaps and Derivatives Association. « Even if it were the right thing to do-which we would dispute-[Papandreou is suggesting] doing it at a time when the market remains very sensitive to creditworthiness. You would heighten uncertainty, » Metcalfe told me.

Other economically shaky nations are not bellyaching. About 45 of the top 1,000 most-active CDS are for sovereign nations, with higher volume for Brazil and Turkey than for Greece. Greek politicians, however, need a scapegoat. Speculators, says Papandreou, « only place value on immediate returns, with utter disregard for the consequences on the larger economic system, not to mention the human consequences of lost jobs, foreclosed homes, and decimated pensions. » I can make this same case against politicians.

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