Of PIGS And Elephants

We all know the pitfalls of comparing apples to oranges. But what of pigs and elephants? (Note: PIGS = Portugal, Ireland, Greece, Spain).

Case in point, the sovereign debt crisis which started in Greece and spread to Portugal, Spain and other such debt-fed porcines. It wasn't long before Italy, France and other EU nations started feeling the ripples in their government bond prices. Even Germany, that beacon of uber-conservative government finances, saw its CDS prices climb higher.

Analysts, financial journalists and global pundits are now falling all over themselves to criticize the Greeks for the mess they made. Nouveau-popular Roubini and Taleb have gotten in on the act and a day does not go by without mention of Greece in the front pages of major financial networks (Bloomberg, Reuters, WSJ, FT..). They have even unearthed a funky $1 billion cross-currency swap from 2002 arranged by Goldman Sachs (who else?).

Ahhh.. as the ancient Greeks used to say: Δρυός πεσούσης πας ανήρ ξυλεύεται (once a tree is felled everyone can be a lumberjack). To use yet another allusion, the Greek pig is being sacrificed at the altar of "high" finance.

And who's the elephant? Why, the USA of course! Compare the size of projected budget deficits for 2010: Greece $27 billion, USA $1.6 trillion - and that's just the federal deficit, i.e. excluding state and local deficits. And everyone is hyperventilating about the Greeks' ability to borrow? Oh, puh-lease!

It is evident to even the least suspicious observer that what is going on is a concerted effort to besmirch the euro in order to drive the dollar higher. Why? Because the US needs to borrow on a gargantuan scale from foreign investors. Since the US cannot pay high interest rates (they would destroy the economy), it must make Treasury bonds attractive in other ways, i.e. through the dollar exchange rate in the FX market. What matters to a foreign bondholder is total return: interest plus FX gains.

Pretty simple to see the picture when the dots are connected..

Insurable Interest And CDS

The Greek debt crisis is a perfect example of what is wrong with the Credit Default Swaps market. As I have said many times previously, starting in 2007, CDS are not real swaps (as in forward FX swaps or interest rate swaps) but insurance contracts. (I am more than suspicious that Wall Street and The City came up with this obviously misleading name in order to avoid regulation from the staid and conservative insurance regulators.)

AND... as this very good article in the Financial Times makes clear, everyone in the CDS market plays with fire without having any insurable interest in the underlying credit risk (i.e. without owning the bonds). The FT writer says it succintly: "We have given Wall Street huge incentives to burn down your house".

The "arsonists" are to be found everywhere in our investment community (a better term would be juvenile delinquent gang) and they are profiting mightily: pension funds make hefty premiums from selling CDS, investment banks make fat profits by "making markets" ( e.g. Greek CDS commonly have 20 bp bid-offer spreads) and by attacking bonds directly, hedge funds make a quick buck by buying and selling CDS. Happy times everywhere, except for the poor people who have to foot the bill in the end, i.e. those who have to borrow.

This utter nonsense has got to stop NOW. Global regulators can do this with two strokes of a pen:

1. You want to sell CDS? Fine - you must become a regulated insurance company with adequate segragated reserves, actuarial departments, etc.
   
2. You want to buy CDS? Fine - show proof of insurable interest, i.e. you must own the underlying bonds.