Among the New York Times’s bogeymen these days are credit default swaps and derivatives in general. On Friday, the paper’s editorialists tried to blame such instruments for the financial crisis in Greece. I am not an expert on derivatives, so I asked a friend who is an expert to evaluate the paper’s arguments. Here is his response:
The New York Times offered in its lead editorial yesterday what has become routine for that newspaper in its op-ed pages as well as its general and business news: a screed against credit default swaps (CDS), financial derivatives contracts and, by extension, high finance and Wall Street generally.
This time the focus is on financial crisis in Greece and the claimed role of Wall Street ands its fiendish inventions in bringing on or aggravating the crisis. After years and years of excessive government spending, debt, corruption, iron control by public sector unions and socialist politics, reality has bitten Greece and threatened the stability of the Euro, the other weak economies in the EU (the “PIIGS”: Portugal, Italy, Ireland, Greece, Spain), and perhaps the EU itself. Naturally, none of these fundamental factors driving social democratic regimes are to blame; the problem is with Wall Street for first enabling Greece and then later “betting against” Greece in each case with those “particularly complicated” instruments known as derivatives. Ominously — cue the scary organ music — there were CDS instruments involved….just like with AIG!….the horror! The Times follows with the usual laundry list of “problems” and “reforms” directed at Wall Street and derivatives.
The errors, misrepresentations and apparent fundamental incomprehension found here and in general in the Times’ coverage of the financial crisis are voluminous. I cannot do better than the formidable Felix Salmon writing in his blog at Reuters in taking apart the Times coverage of the Greece crisis and CDS contracts:
“A.I.G., Greece, and Who’s Next?”….The headline alone made me ill-disposed towards the editorial…What a mess. The news that Greece had entered into derivatives transactions with Goldman Sachs came in 2003, almost seven years ago. The reports about hedge funds using derivatives to bet against Greece and the euro have already been discredited. And AIG was not brought down because people were buying credit protection on it, it was brought down because it was selling credit protection on subprime mortgage bonds.
He goes on to make the point in response to the Times bleating about facilitating non-transparent risk-taking that the CDS market is actually beneficial in this respect:
But dangerous risk-taking is actually a good thing, in financial markets. When people engage in risky behavior on Wall Street, they stand to lose a lot of money, but they know that they stand to lose a lot of money, and government doesn’t end up having to step in and bail them out. The big systemic problems happen when leveraged actors think that they’re not engaging in risky, speculative behavior…
Earlier this week Felix took apart the designated New York Times hit squad on CDS and derivatives reporting, as he has in the past; one of these Times reporters is actually a former fashion editor at Vogue…..high finance, high fashion…what’s the difference?
The Times’s recommendations in the Greece editorial are based on the usual erroneous claims about the derivatives markets:
– “Transparency” and the need for regulated exchanges; but this is actually a big so what? It is important to note that in a sense the CDS market IS “regulated”…by the participants themselves….who have every interest in insuring that they have standard contracts, clearing mechanisms, netting arrangements, collateral positions, risk management protocols and transparency. CDS contracts ARE transparent, if not to the public, to the participants, in all material respects. And any implication that lack of “transparency” means they cannot be priced properly is just wrong. They are relatively straightforward to price and have readily available liquid markets — MUCH more so than the cash bond markets themselves.
– Derivatives are “gambling”; this claim has been effectively debunked as a fundamental misapprehension so many times that it is simply naïve or disingenuous of the Times to repeat it; gambling, by definition, involves purely random events about which one can inherently have no informed opinion as to the outcome; it has an expected value that is negative; and (other than as entertainment) has no economic function.
– Derivatives markets have an incentive to drive down bond prices or induce a default to create a credit event they can profit from; another claim that is laughable and has been debunked extensively. All derivatives get their value from something else — the “underlying” asset the value of which depends on fundamentals. If the fundamentals of a credit are sound no derivative holder can induce default. If they are not, THAT’S the driver of value simply REFLECTED in the value or price of derivatives. And only on one side, since they are zero sum instruments….someone ELSE has an incentive to preserve value!
The fundamental misapprehension here is blaming the thermometer for measuring the temperature of the fever. As a Citibank customer report this week noted, it is not the mirror’s fault that your face is ugly.
In the end, the Times wants to blame the overall financial crisis on “complex” derivatives and behavior of market participants on Wall Street whom they envy and resent. Remember the Gail Collins op-ed where she openly said “I hate everyone in finance”?
Whatever merit there may be to the call for essentially minor technical fixes in the CDS market, that issue is just a sideshow. The subprime residential mortgage market on the other hand, more or less starting with those mortgage loans originated from about 2005 on, is the entire source of the financial crisis. It is political forces from the left that sponsored Fanny Mae and the extensions of sub-prime credit. Only the government could have created these conditions, which the market responded to. But evidently the MSM memo has gone out…the designated scapegoat is the CDS market…and there will be a relentless assault on anything in the financial world that is complex and quantitative and therefore mysterious to journalism majors. Of course the left is untroubled by this since it is an opportunity to orchestrate through the MSM an assault on free markets and financial innovation leading to increased power over the private economy from Washington.
UPDATE: A reader writes:
This letter to the SEC on financial reform is helpful for general context–both on the meltdown and the direction reform should take.
As for Credit Default Swaps, several basic facts are missed by the mainstream commentariat:
– A credit default swap is itself a risk reduction mechanism. In the most basic terms, it is an insurance policy taken out to protect against default on the underlying credit.
– The trading of credit default swaps is a market driven means to determine the risk of a credit. This is in contrast to the Nationally Recognized Statistical Rating Organizations (NRSROs), which were the traditional government-driven oligopoly scheme to determine credit risk. I am talking Moody’s, Standard and Poor’s, Fitch. The CDS market was a much more accurate indicator of default risk than were the NRSROs. I should add that sophisticated debt market critics have long argued for more rating agencies and elimination of the government’s role in limited the number of NRSROs. Luigi Zingales and other UofC types have even argued that CDSs should be the preferred way to “rate” default risk.
– The great Financial Armageddon of 2007 – 2008 was not a grand indictment of capitalism, but rather a very simple problem: $2T in AAA mortgage-backed securities had no business being rated AAA and were grossly mis-priced considering the risk they represented. The CDS market was the canary in the coal mine on this state of affairs.
Of course, I should add that the moral hazard represented by the AIG bailout in this regard cannot be underestimated.
In addition to the quality of the underlying credit, a Credit Default Swap is priced by the solvency of the insurance counter-party.
By bailing out AIG (whose board included Richard Holbrooke) and by extension Goldman Sachs, the concern understandably increases around Credit Default Swaps being generally underpriced, over-used and hence susceptible to being “fake” insurance.