The need for smarter CDS

The financial crisis was blamed on two new instruments – collateralized debt obligations (CDO) and credit default swaps (CDS). More recently, the naked CDS were banned in response to Greece woes. In the first instance, the blame was partly warranted, since CDS with no collateral postings and no central clearing place (CDS dealt over-the-counter), allowed some financial institutions to take larger risk on their balance sheets than would be otherwise possible. In the second case, it is now clear that banning of short selling was an empty gesture with no real (positive) effect. But in a way, CDS played their role in Greece crisis, even though exactly opposite than their critics claim – they are guilty of omission, not commission. It is now clear, that Greece crisis was created long before it became apparent, in the pre-2008 years, when the country was allowed to borrow far more than it can handle.

The point is that CDS and especially naked CDS are perfect instrument for speculation. This is because the fact that they often do not require collateral postings and allow speculation where it was not before possible, since there were no securities to sell short. It is more than abundantly clear from Michael Lewis great book “The Big Short”, that CDS at one hand allowed some institutions to take more exposure than they would be (and should had been) able to do otherwise, but on the other allowed the few who were brave and farsighted enough to speculate against the subprime madness.

Indeed what was the problem before the crisis was that there was not enough speculation against the bubble. The number and purchasing power of speculators was not large enough, even after enhancement provided by CDS. This applies to Greece case as well, because if there was enough speculators exposing the clear truth, that Greece is heading towards default, during the 2000s, Greece would not be able to indebt itself to its current degree.

But can anyone blame them? Look at the current situation, when authorities want to avoid credit situation (i.e. official default) by any means. One of the reasons of course is that it would trigger payments on CDS. While this behaviour is perfectly rational from the damage-containment perspective, it comes at huge price into the future. No speculator sane enough will bet that any country will go bankrupt, knowing that there will authorities doing everything possible to avoid paying him. In economic language, this clearly points towards something we know very well in respect to monetary policy – time inconsistency. No matter what they say before, government officials will bail out their peers, because at the given moment it’s the right thing to do. That is, it is the right thing if we take in respect only current period.

If we extend this analysis to past, speculators were probably right to lend to Greece whatever its situation was, believing that default will not happen. (Of course, those holding the bonds and selling them were hit, but so far no owner of CDS was paid). What is then to be done? I propose (without any knowledge of the peculiarities associated) new generation of smart CDS. CDS, which would take into account the possibility of government-led bailout and would be payable even in such case. This would improve markets in the Arrow-Debreu sense by allowing speculators to avoid the risk being denied profit due to government action. Furthermore, it would directly price the advantage accruing to too-big-to-fail institutions and countries, setting platform for aligning incentives.