From Europolitics:
The European Parliament is attempting to rid the EU of speculators betting on Greece going bankrupt, voting for a ban on the practice of naked short-selling of credit default swaps... CDSs are insurance-like contracts that pay the buyer if a country or company goes bust.
OK.
Buying a CDS is analogous to buying insurance.
If you own a house, you are "long" of a house and you can insure it against the risk of it burning down. The insurance company doesn't own your house (the bank does, probably). It is gambling on your house not burning down (or fewer houses burning down).
If you own Greek bonds, you are "long" of Greek bonds. You can insure against default by buying a CDS. The seller of the CDS doesn't own Greek bonds, and is gambling on Greece not defaulting.
The owner buys insurance, the insurance company sells insurance. You buy a CDS, the insurer sells a CDS.
If you own Greek bonds and buy a CDS, your risk is 'covered' and you are now indifferent whether Greece defaults. The insurance company has sold you a "naked" CDS and has every interest in Greece not defaulting.
The general rule in insurance (apart from life insurance) is that you can only insure something up to the lower of its value or replacement cost; if you over-insure, you have every incentive to burn down your own house and pocket the difference.
Now imagine, I could buy "naked" insurance, i.e. I don't own Greek bonds (or your house) - then I have every incentive to trigger a Greek default (or to burn down your house). And as we know, setting fire to a house is easier than preventing other people from doing so - there is assymetry of risk here.
So it's the BUYERS of "naked" CDSs who cause the problem (to the extent that there is one) and not the SELLERS - all insurers are by definition "naked" sellers. Greece (or its new rulers, the EU) ought to be rejoicing every time a major financial institution sells naked CDSs because this institution has just put itself in to bat for Greece.
Here endeth.
Nothing subtle about it
2 hours ago
17 comments:
So it's the BUYERS of "naked" CDSs who cause the problem (to the extent that there is one) and not the SELLERS - all insurers are by definition "naked" sellers. Greece (or its new rulers, the EU) ought to be rejoicing every time a major financial institution sells naked CDSs because this institution has just put itself in to bat for Greece.
But hasn't every sale also created an enemy of Greece? If you ban sales you have banned both the seller (whom you correctly point out we are fine with), and a buyer (who you correctly point out we are not fine with).
Given that destruction is easier than construction, surely it's better for the Greeks that neither exist than both exist?
(Personally, it's the "naked" part that bothers me. I have no problem with short selling when you have some skin in the game)
OP: "But hasn't every sale also created an enemy of Greece?"
If the buyer owns Greek bonds, then no. The insured owner is now indifferent whether Greece defaults or not.
If the buyer is a naked buyer, then yes. But we can deal with naked buyers quite simply by relegating the status of such contracts to the status of gambling debts - while not illegal, they are not enforceable in a court of law.
"I have no problem with short selling when you have some skin in the game."
How so? If I own bonds, I am "long". If I sell bonds, I am short - by definition, I have negative skin in the game.
If I sell insurance, then I very much have skin in the game - indirectly I am in a similar position to somebody who owns Greek bonds without insurance (i.e. both I and he bear the risk of a default).
Forgive me if I am wrong here, but my understanding is that "short selling" of something is where you agree to buy shares or whatever at some point in the future and sell them now, gambling on the price being less in the future than it is now. "Naked short selling" is the same thing without the agreement, i.e. you are not only gambling on the price being less, but also on the shares being available to buy. So the people "naked short selling" CDSs are neither the insurance companies nor the original buyers, but simply third party gamblers.
B: My understanding is that "short selling" of something is where you agree to buy shares or whatever at some point in the future and sell them now, gambling on the price being less in the future than it is now."
Correct.
"Naked short selling" is the same thing without the agreement...
Nope.
If you own something and agree to sell it for a fixed price in future, that is FORWARD selling. If you don't own it and agree to sell it for a fixed price in future, that is SHORT SELLING which by definition is NAKED SHORT SELLING. The word "naked" is actually superfluous.
"So the people "naked short selling" CDSs are neither the insurance companies nor the original buyers, but simply third party gamblers."
OK, they are clearly "third party gamblers" but they are gambling on Greece NOT defaulting!
What this goes to prove is that the collective wisdom of the 'market' is always superior to the limited understanding of central planners - politicians or bureaucrats. What pisses them off mightily is that they have no way of controlling the rest of us, and that for a politico/functionary is a Big Issue. They went into government so that they could enjoy themselves telling us all what to do and then getting there find they can't and have no idea what's going on. Market solutions like CDS's confound their intrisic authoritarianism, and they can't have that.
The real thing I cannot get my head around is why have the CDS in the first place?
Surely, if there is a chance of somebody/thing defaulting on its debt, then the money should not have been lent in the first place? Or at a coupon that covers the extra risk of any default.
Let’s face it; these things have really got “us” over a barrel by supposedly eliminating risk. Without the risk calculations, I would lend money to everybody regardless of credit rating.
Oh hand, they did lend to anybody.
Got to stop now, my rage is building.
L, up to a point. The problem here is that 'the markets' (i.e. 'the market manipulators') and the government are largely the same people.
MN: "The real thing I cannot get my head around is why have the CDS in the first place?"
Me neither. The cost of the CDS more than wipe out the interest rate premium, so why not just sell the Greek bonds and have done with it?
MW, yeah, I know that in this instance, but the principle applies.
In re why do we have CDS's - quite. I have never been able to undertand why the vast majority of these sorts of things are bought. I know why they are sold - they make money for banks. But as for buying, why bother? The premium always equates roughly to the expected return. This is very true in retail FS with 'guaranteed funds' where the cost of the guarantee eats out most if not all of the expected return.
""Naked short selling" is the same thing without the agreement...
Nope."
Perhaps you should edit the Wikipedia article on Naked Short Selling which starts thus:
Naked short selling, or naked shorting, is the practice of short-selling a financial instrument without first borrowing the security or ensuring that the security can be borrowed, as is conventionally done in a short sale.
You can't stop people making contracts via regulation. You can make them unenforceable in law, but you can't stop people making them.
There is so many different ways for either the retail punter or big hedge fund to get short exposure to something. All manner of derivative contracts, options, futures and forward contracts exist.
The one that bugs me with CDS is that people seem to be able to write more of it than they can afford to cough up on. If they are 'too big to fail' and will get a central bank or taxpayer bailout in the event they do have to cough up (like when AIG went belly up, or Long Term Capital Management before it) then thats just silly.
That's like me laying loads of odds on stuff on betfair and in the event too many of them come in the government paying my losses.
A one way bet.
B, fair point (although I would describe covered short selling as 'forward' selling) BUT insurance, is always 'naked'. You own a house, you insure it. How can the insurance company cover its risk short of keeping its fingers crossed (or passing on the risk to somebody else etc etc)?
SL, agreed, that's what L meant.
The other thing wrong with this proposal is that the buyer will just go overseas.
So the only difference it will make is to move the transaction outside the EU.
Typical political soundbite.
Ed: "The other thing wrong with this proposal is that the buyer will just go overseas."
Overseas? Would they first have to brave the stormy and treacherous oceans which separate Switzerland from Germany or Italy?
Overseas? Last I heard the Isle of Whight was pushing to become and 'international financial centre'.
"Last I heard the Isle of Whight was pushing to become and 'international financial centre'."
Well, it's an island in the English Channel and the other Channel Islands are tax havens, so it's got to be worth a try.....
Why do CDS exist? Oh for all sorts of reasons beyond the obvious. For example, let's say that I don't want to suffer the fall in price of a Greek bond I own as an asset when the auditor comes in. I claim that I don't intend to sell it ever and I am holding it to maturity, and I insure it with a CDS. That way I don't have to 'mark to market' and can pretend it is worth more than it is.
Or, I may issue CDS on my own debt to pretend that it is lower risk than it really is. No really. The price of the CDS signals the confidence in the debt, so to drive down medium term interest rates, the Federal Reserve issues CDS on US government debt.
L: "the Isle of Wight was pushing to become and 'international financial centre'." Presumably where they still enter all transactions into a ledger using a quill pen and still use guineas, pounds, shillings and pence.
B, no it hasn't.
OTOH: "I don't want to suffer the fall in price of a Greek bond I own as an asset when the auditor comes in. I claim that I don't intend to sell it ever and I am holding it to maturity, and I insure it with a CDS."
Nice one, a bit like Lehman's Repo 105 transactions.
Post a Comment