Megan McArdle and Felix Salmon run roughshod over the NYT


I’m not even going to try to enumerate all the inaccuracies here. Were credit default swaps really pivotal in the U.S. crisis? They certainly brought down AIG, and a couple of smaller monolines. And they made synthetic CDOs possible — without them, the “unfunded super-seniors” which did so much damage to many huge banks could never have existed. But they weren’t pivotal in the sense that absent CDS, the crisis wouldn’t have happened.

But we’ll give the NYT the “pivotal role” bit just because it’s simply untrue that credit default swaps “are emerging as one of the most powerful and mysterious forces in the crisis shaking Europe”. (Even assuming there is a crisis shaking Europe.) In what way, exactly, are CDS emerging as particular powerful in the latest Eurocrisis? CDS volumes on Greek debt are a fraction of the total amount of debt outstanding, and certainly no sovereign has written huge amounts of credit protection, thereby racking up enormous contingent liabilities, in the way that AIG did. In fact, European sovereigns aren’t players in the CDS market at all.



You see this sort of folk mythology among market watchers very frequently.  They note that there are financial instruments which convey negative information about the soundness of the underlying institution.  Furthermore, they quickly realize that just before institutions fail, there is often quite a lot of activity in those sorts of financial instruments.  Therefore, if you could only eliminate the instruments, you could also eliminate the failures!


I don’t know enough about Greece’s situation to say whether or not CDS played a pivotal role but it is certainly theoretically possible. That is, one need not be quite as dull as Felix and Megan suggest, in order to believe that financial instruments could break a country.

I suspect and Felix seems to confirm that the market for CDS on Greek debt was orders of magnitude smaller than the market for the debt itself. Its therefore far more vulnerable to manipulation whether purposeful or accidental.

Buying large quantities of over-the-counter protection on Greek debt could cause discontinuous jumps in the price. Because the CDS is over-the-counter we would not expect the market to move in constant equilibrium but in a jerky fashion as buyers and sellers discovered one another.

Nonetheless, CDS on debt carries a lot of information. The holders of sovereign debt are typically looking for one of the securest investments in that currency. The mechanics of this are much more complex for a currency union like the Eurozone. Nonetheless, It seems reasonable that a significant portion of Greek debt purchases are not interested in doing detailed analysis on the Greece’s credit worthiness.

A spike in the CDS on Greek debt means that some set of parties who are interested in the creditworthiness of Greek debt have contracted on the assumption that the creditworthiness is getting worse.

That’s enough to encourage one to stick his Euro’s elsewhere and importantly its enough for some to believe that others will want to stick there Euro’s elsewhere.  Such a move would lead to higher interest rates for Greece and hence an even rougher time paying back its debt. Hence, if I think all of this might happen, it becomes in my interest to get out.

This is the key difference between debt and equity on the functioning of an enterprise. If someone raids my equity that might not be good for my shareholders but generally speaking it doesn’t curtail my ability to do the things I want to do.

If someone raids my debt, however, that leads to a chain of worry about who will be the last person holding my debt and in turn makes it far more difficult to issue or turn over debt.  This in turn can break me. So, running a stock and running CDS are totally different beasts.

Now, like I said, I really don’t know or claim to know a lot about Greece’s situation. I am only arguing that the notion that “the CDS did it” is not crazy from an enterprises point of view.