It Isn’t About Greece. It’s About Las Vegas
Dolors & Sense
by Sanford Rose
KISSIMMEE Florida—(Weekly Hubris)—6/27/11—The Greek debt crisis is tragic enough for the people of Greece.
It may prove catastrophic for the people of the world because it is only a chip in a floating craps game that should have been regulated or closed down years ago but is still flourishing.
The main danger to global health from the Greek virus comes not from the Greeks but, as is often pointed out, from the contagion effects of Greek default on the Portuguese, Irish, and especially the Spanish.
And it doesn’t necessarily come from the impact of bond defaults on the balance sheets of lending banks and other bond investors.
In fact, it is probably the case that the banks are already fully or more than fully hedged against the impact of any Greek default.
The problem comes from the method by which they hedged themselves. They did it by using our old friend from 2008—the credit default swap.
The banks paid premiums for insurance against an “adverse credit event.” That sounds like a legitimate protective activity—transforming a net long position in Greek debt into a neutral or even a short one.
But in order to go short, the banks had to find someone willing to go long by selling them protection.
Very likely, that someone—an insurance company, hedge fund, or pension fund—had no cash position in Greek bonds. They were just speculators, using “naked” credit default swaps.
That’s when institutions either buy or sell protection against the default of a bond or other credit instrument even when they don’t own the debt in question and therefore have no direct need to offset credit exposure.
They buy protection, if the premium is low enough, if they expect an actual default or any other aggravating economic event that would cause premiums to increase. If their expectations are correct, they make a profit by in turn selling or liquidating the swap.
They sell protection if they expect matters to improve and the premium to fall, in which case they also profit either by booking or realizing a capital gain.
Although there is comparatively little activity in Greek credit default swaps, there is a tremendous amount of such activity in other Eurozone bonds. So if Greek default triggers the default of other countries, large losses could show up in the strangest places.
Now, for every loss, there should be an offsetting profit. But suppose the loss is taken by a teetering financial institution (of which there are so many) which can’t pay out. Then, instead of a profit balancing a loss, we may have two losses—and possibly two failed financial institutions.
The credit swap market, and especially its “naked” component, is so large—trillions of dollars—that this is a real and ominous possibility.
There is therefore a good case for banning the naked credit swap. It turns financial institutions into players in a Las Vegas-type casino who can be, and often are, wiped out by one ill-advised bet.
Wall Street may look like Las Vegas to many of its denizens, but the world may be pardoned for insisting on proposed but long-delayed aleatory curbs.
Sanford Rose
Sanford Rose, of New Jersey and Florida, served as Associate Editor of Fortune Magazine from 1968 till 1972; Vice President of Chase Manhattan Bank in 1972; Senior Editor of Fortune between 1972 and 1979; and Associate Editor, Financial Editor and Senior Columnist of American Banker newspaper between 1979 and 1991. From 1991 till 2001, Rose worked as a consultant in the banking industry and a professional ghost writer in the field of finance. He has also taught as an adjunct professor of banking at Columbia University and an adjunct instructor of economics at New York University. He states that he left gainful employment in 2001 to concentrate on gain-less investing. (A lifelong photo-phobe, Rose also claims that the head shot accompanying his Weekly Hubris columns is not his own, but belongs, instead, to a skilled woodworker residing in South Carolina.)
6 Comments
eboleman-herring
Great explication of the current complexity that is Greece. Now, a piece sheerly on Futures???? Please?
srose
The future of Greece depends on its growth potential. Can Greece sell anything else but sunshine? Or can it build and run the infrastructure needed to sell that sunshine in the form of electric power to its EC partners? Jeff Sachs, who is just about the best development economist around, thinks it can. But if the potential growth rate of output is dwarfed by the rate of real interest on the external debt, then the burden of debt gets progressively heavier, and the country slides back into bankruptcy. So Jeff, along with others, thinks that the EC has to guarantee the debt in order to reduce the interest burden to manageable proportions. To buttress that guarantee (and make it politically palatable), one needs an additional source of non-state revenue. Many suggest a special tax on EC bank transactions.
Another school of thought is of course the one that favors devaluation. Flee the euro, set a low enough rate on the drachma, impose capital controls to prevent bank balances from disappearing abroad, and develop export markets based on low-priced goods.
eboleman-herring
Sanford, as things stand today–July 3–after recent parliamentary actions in Athens, is there still a chance Greece might return to the drachma?
srose
Not until the next crisis, which is unlikely this year but may occur because it is administratively impossible to implement austerity measures. The focus now shifts to Wahington, which may soon show that it is just impossible to administer.
Heather Tyler
The chips are down in Greece, there are no more chips to cash in. Greece is a high-profile symptom in a big crap game. I doubt Greece could afford to return to the drachma.
srose
There is no solution to the Greek problem without a fall in the Greek living standard. Austerity or devaluaton of a recontituted drachma both lead to lower Greek claims on the world’s resources. The only question is that of contagion. If European banks stumble, what happens to the US money-market funds that buy their commercial paper? Will they have time to close out their positions? Will they even want to do so if palliative measures keep causing them to underestimate the gravity of their exposure? If the money-market funds lose money, will we see a Lehman-type financial panic? The handling of the Lehman fiasco prevented a widespread run but was so inept in other respects that it served greatly to deepen the 2008-2009 recession, the effects of which remain much in evidence today.