Nudity and the Financial Markets

UWE E. REINHARDT




Last week Chancellor Angela Merkel of Germany banned naked credit-default swaps on the bonds of European governments and naked short sales of the stock of the country’s 10 most important financial institutions.
Chancellor Angela Merkel in Qatar on Thursday.Karim Jaafar/Agence France-Presse — Getty Images Chancellor Angela Merkel in Qatar on Thursday.

The ban spooked the financial markets, even while commentators argued that the ban could easily be circumvented if other nations, notably the United States and Britain, refused to join — and because the ban, apparently, does not apply to branches of German financial institutions outside of Germany.

The ban also brought stern lectures from America’s commentariat.

In a lead editorial, “Angela Merkel’s mistake: Battling the financial markets,” The Washington Post on May 22 harrumphed: “It was so transparently political and, in policy terms, so irrational that it raised doubts about Berlin’s leadership in the euro crisis. Whatever short-term domestic political benefits it had were offset by the damage it caused, and may yet cause, on financial markets across the world.”

So what is all this fuss about? Who is right here, and who is wrong? Take your pick.

First, some definitions.

Short Sales: In a traditional short sale of a financial security, the seller does not own the security but, for a fee, borrows it from a bank or a broker before selling it to a buyer.

The short-seller bets that the security can subsequently be purchased at a lower market price and returned to the lender, leaving the seller a tidy profit. Naturally, the deal produces a loss if the price of the underlying security instead rises.

Naked Short Sales: In this case, the short-seller borrows the security only after the sale. Although in principle the shares must be delivered to the buyer within a specified time (three days under American law), in practice that stricture often is observed in the breach.

Naked short-selling is controversial, because without the constraint of actually having the security in hand, short-sellers can dump a huge volume of a security onto the market in a so-called “bear raid,” depressing the security’s price in a self-fulfilling prophecy. It has been argued, for example, that some financial institutions in the United States were victims of bear raids in 2008-9, which is why in 2008 American authorities banned such short sales for a time, even though the United States had chided Japan for doing so during Asia’s 1997 financial crisis.

Credit-Default Swaps: These are a form of insurance under which the seller agrees to protect the buyer against default on an underlying debt instrument — for example a corporate bond, a government bond or a so-called “structured security,” such as a mortgage-backed security.

In return for that protection the buyer pays the seller quarterly or semiannual premiums expressed in basis points (one percentage point being 100 basis points) per year of the amount of the debt (the “notional”) being so protected. This premium is also called the “C.D.S. spread.”

For example, the credit-default-swap spread on five-year Greek sovereign debt was about 250 basis points in January. This means the quoted annual premium to insure $10 million of five-year Greek government bonds against default was about $250,000. By early May that spread had risen to more than 800 basis points.

Credit-default swaps originated in the United States in the mid-1990s to protect owners of debt instruments against default. Occasionally one finds these instruments referred to as “clothed” swaps. They are a highly innovative and useful derivative for hedging risky investments.

Naked Credit-Default Swaps: In fact, one does not need to own a particular debt instrument to purchase credit-default-swap protection on it. Indeed, one does not even need to know who owns the bond.

Just as one can place bets on the performance of a race horse without owning it, one can place bets on the performance of a debt instrument without owning it. A credit-default swap sold to someone who does not own the underlying debt instrument (the “reference bond” or “reference notional”) is called a naked credit-default swap.

All such swaps, including originally “clothed” ones, can be traded as separate contracts in the market. Because the spreads on a particular debt instrument change over time, one can profit (or lose) by trading swaps. Currently, the market for them is comprised predominantly of naked swaps, because multiple ones can be sold on a particular debt instrument.

After the bailout of American International Group, a large seller of credit-default swaps before 2008, by Ben S. Bernanke, the chairman of the Federal Reserve, and Timothy F. Geithner, then the president of the Federal Reserve Bank of New York and now the Treasury secretary, naked swaps came under sharp criticism. Some people made the analogy to loaded guns in the hands of teenagers.

For example, none other than George Soros, surely one of the more astute financiers of our time, has advocated their outright ban.

The financial regulation bill recently passed by the House of Representatives and about to go to conference with the Senate also contains a ban on naked swaps.

The comparable bill passed by the Senate might well have included such a ban under Senator Byron Dorgan’s amendment had not Republican senators voted as a bloc against the amendment.

But naked swaps have their staunch defenders, in the United States and elsewhere.

The Treasury opposes a ban on naked swaps. And although Finance Minister Christine Lagarde of France singled out credit-default swaps in February as a main culprit in the worsening euro crisis, she was upset when Chancellor Merkel did not consult her before Germany banned naked swaps on European sovereign bonds and now says that France will not ban such contracts.

Finally, with the hauteur that seems to be the American trademark when we lecture the rest of the world — and which is highly resented abroad — The Washington Post (in the editorial cited above) said Chancellor Merkel “seemingly does not fathom that naked credit-default swaps can provide an early warning system — in the absence of which profligate entities, such as Greece’s government, may be enabled to extend their profligacy.”

It is a point that evidently eludes Mr. Soros and a majority of the House of Representatives as well.

One would think that if naked swaps were invariably traded among mature, socially responsible traders, Mr. Soros and Ms. Merkel would easily see The Post’s point.

Spreads on purely speculative naked swaps can indeed serve as a useful sentinels of brewing asset bubbles or of excess leverages. They can also be used as a genuine hedge on assets for which direct hedges are not available. That will always make it difficult for regulators to distinguish between the truly speculative naked and the quasi-clothed swaps, if it is the purely speculative swaps bets they wish to curb.

But “mature” and “socially responsible” are not adjectives that spring to mind when one thinks of the financial markets.

We are dealing, after all, with institutions whose reckless swaps trading contributed significantly to the systemic risk that ultimately dragged taxpayers to the rescue.

We are dealing with institutions that hid the perilously high leverage on their own balance sheets with cleverly designed repurchasing agreements or off-balance sheet, offshore structured investment vehicles that fooled both the Federal Reserve and the Treasury into a false sense of normality, until the financial houses of cards the financial institutions had built collapsed and, as teenagers in trouble run to Mommy, the bankers ran to government for a bailout.

Finally, we are dealing with institutions that exported their clever expertise of hiding debt to the very same countries whose debt they now bet with credit-default swaps will default, such as Greece.

And therein lies a major obstacle to a unified reform of global financial markets.

There was a time, in the early 1990s, when Treasury Secretaries Robert E. Rubin and Lawrence H. Summers and the Federal Reserve chairman, Alan Greenspan, could strut about the globe, assuring everyone that derivatives need not be regulated, because the world’s financial markets are operated by mature, smart, rational people and, therefore, are self-regulating. Americans and the rest of the world believed them and acted on their advice.
Treasury Secretary Timothy F. Geithner in Berlin on Thursday.Lennart Preiss/Associated Press Treasury Secretary Timothy F. Geithner in Berlin on Thursday.

These times are gone.

Travel abroad and talk to leading business people and politicians. You will learn that America has lost its role as the shining beacon on the hill of financial and macroeconomic policy. Seeking a coherent reform of global financial markets henceforth will be like herding cats.

As this post is written, Mr. Geithner is traveling in Europe, once again doling out gratuitous advice on how Europeans ought to conduct their economic affairs. As The Wall Street Journal reported this week, the tone of the lectures is reminiscent of the advice the Clinton administration, including Messrs. Geithner and Summers, doled out to Asians after their financial crisis of 1997 – ironically just at a time when the American financial market was busily blowing hot air into its own dot.com bubble, which burst in 2000, and which was quickly followed by the made-in-the-United States subprime mortgage bubble, which burst in late 2007.

We shall see how dutifully the Europeans copy down and follow America’s lecturing. Don’t bet on it. Instead, buy a credit-default swap on California bonds.