Germany: Right and wrong on naked shorts
Those who criticise the German government for trying to restrict the use of naked shorts and credit default swaps (CDS) are – on the whole – concerned about the when and the how, rather than the whether.
Or to put it another way, there are strong arguments for restricting the use of credit default swaps, or insurance policies for loans, in that their use exploded well beyond what could seen as sensible protection against loans going bad.
At their peak a couple of years ago, there were $60 trillion of extant credit default swaps, insuring loans with a value of around $6tn. This was the equivalent of taking out 10 buildings insurance policies on a single house, or 10 life policies on one individual.
The point is that $6tn of credit default swaps would have provided appropriate cover for the risk that the loans might go bad.
And just as you might feel a bit anxious if your neighbours took out nine insurance policies that would enrich them in the event that your house burns down or you pop your clogs, it is reasonable to fear that the other $54tn of CDS contracts were not all taken out with the purest of motives.
As I’ve pointed out before, many of these CDS contracts were a way of speculating in the fortunes of a business or a government, without the regulatory hassle of trading on a transparent, well-scrutinised, regulated exchange.
If a hedge fund or speculator thought that a company, government or specially created investment product, such as a collateralised debt obligation, were going to the dogs, a CDS was (and is) a way of making a killing from their respective woes.
And, perhaps best of all, that killing could be made well away from the prying eyes of media or regulators: it was the last frontier of a financial wild west.
None of which would have mattered all that much if – to coin a phrase – the cowboys in this financial Wild West had only hurt their own.
The problem is that many of the world’s biggest financial institutions, giant insurers such as AIG and assorted banks, couldn’t resist the gold rush – but found themselves on the wrong side of these CDS deals.
So when the speculators made profits, the insurers and banks made enormous losses. And the tab for these losses was eventually picked up by taxpayers, because (as you’ll be tired of hearing by now) the damage to all our prospects would have been unbearable if we’d allowed these cornerstones of the economy to crumble.
All of which is a meandering explanation for why there is a powerful argument for reforming the CDS market.
As you’ll deduce, there is a strong case for banning naked CDS’s, or the use of credit default swaps by those who don’t actually own any of the relevant debt being insured.
There are also good reasons for forcing all CDS trades through transparent, regulated exchanges and clearing houses, to provide some kind of verification that they’re not being used for insider trading, and to ensure that counterparties to deals put up appropriate “margin” or cash when prices swing as proof that they have the wherewithal to honour the contracts.
Here’s the thing however.
It’s quite possible to be the world’s harshest critic of the explosive growth of credit default swaps and still take the view that the German government took leave of its senses on Tuesday night when it imposed a unilateral ban on their use in respect of the debt of eurozone governments.
How so?
Well, in the world as it is – as opposed to the world as we might like it to be – the financial institutions who use credit default swaps provide vital loans to eurozone governments and businesses.
And if they’re told that, at a stroke, they can’t use those credit default swaps, well then investment climate for them in the eurozone is perceived to become harsher – and it becomes rational for them to seek to put their cash elsewhere.
The French finance minister, Christine Lagarde, has grasped the risk: she said yesterday that she was concerned that the German prohibition, if followed by other governments, would reduce liquidity in the eurozone government bond market – which, in theory, means that the price of those bonds would fall and would push up the cost of funds for eurozone governments.
There’s a time and a place for radical reform of financial markets. The place is probably the world as a whole, and not just one part of it – because unilateral national initiatives may either be ineffectual or may create dangerous distortions in the allocation of capital around the world.
And the time is probably when there’s evidence that fiscal deficits in Europe are on a pronounced downward trend and economic recovery is entrenched.
The worst time to alienate investors and banks by restricting how they invest is when they are anxious about the strains within the eurozone and can simply shift their money to other places where they feel more welcome.
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