Wednesday, March 3, 2010

Naked CDS and Greece

Sam Jones has a nice column on the benefit of naked CDS and the Greek crisis. It is a critique of the argument of Munchau that:
A naked CDS purchase means that you take out insurance on bonds without actually owning them. It is a purely speculative gamble. There is not one social or economic benefit. Even hardened speculators agree on this point. Especially because naked CDSs constitute a large part of all CDS transactions, the case for banning them is about as a strong as that for banning bank robberies.
Jones shows how hedge funds that were naked CDS are now likely to be buyers of Greek bonds. His argument is twofold:

Firstly, any naked CDS buying – as slated by Mr Münchau – occurred, by hedge funds at least, well before the current crisis. Hedge funds have not been the most significant buyers of CDS in recent weeks. (Banks, stuffed to the gills with sovereign debt thanks to the ECB, have)

Ergo, there is no speculative, opportunistic “attack” underway to try and push Greece further into catastrophe (as Mr Münchau notes, Greece seems content to do this all on its own anyway).

Secondly, and more importantly, however, hedge funds, completing their clever trade, have been buyers of Greek government debt, or else insurers of other holders as CDS writers.

In a market where one of Greece’s principal market makers -– Deutsche Bank –- says it will not buy Greek bonds, and where European politicians are having to force their own national banks to do so in order to try and avert the threat of a Greek bond auction failing, the boon from hedge funds looking to hoover-up Greek debt is undeniable.

And the only reason they are in the market to buy is because of naked CDS positions they laid on many months -– and in some cases years -– ago.

What I don't understand is why his argument is not even stronger and simpler. Hedge funds buy naked CDS when prices are low speculating that a crisis may occur. When the crisis occurs and spreads rise, the hedge funds sell the swaps to those in dire need -- those who are lenders to Greece.

Indeed, isn't this just like any argument for short selling -- that it is providing more market information about what might happen? Suppose that enough hedge funds bought CDS on Greek debt years ago and that spreads rose significantly then. Lending to Greece would have been reduced and the extent of Greece's debt woes today would be smaller. Wouldn't more naked CDS have been better?

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