Are Swaps Helping Create a Greek Death Spiral?

It’s a good idea for The New York Times to point out that Wall Street is betting against Greece after having helped get it in dire straits.

Banks helped Greece obscure its actual debt from regulators (and investors, which seems like where any actual fraud may have been), and now are betting against it, which the Times reports is making it all the more likely that those bets will pay off.

They do that by buying credit-default swaps, which pay off if Greece defaults on its debts. The potential problem here is that by piling into the CDS, the banks (and hedge funds) make it more likely that the CDS will actually pay off. That’s because increased buying raises the cost of the insurance, and bond buyers look at the CDS indexes to help them gauge how risky it is to lend to someone. If they push Greece’s new borrowing costs higher, it increases the difficulty of Greece actually paying its already-huge debts or borrowing more to keep afloat.

Or as a Times source succinctly puts it:

“It’s like buying fire insurance on your neighbor’s house — you create an incentive to burn down the house,” said Philip Gisdakis, head of credit strategy at UniCredit in Munich.

The problem here is it’s difficult to say what Greece’s bonds would be doing if there were no CDS market. And it’s hard to tell when the CDS index goes from being the canary in the coal mine to actually killing the canary itself. I don’t think the NYT is quite clear enough on that. Here’s what it says:

On several days in late January and early February, as demand for swaps protection soared, investors in Greek bonds fled the market, raising doubts about whether Greece could find buyers for coming bond offerings.

The paper is implying here that investors fled Greek bonds because the CDS price went up. But, of course, while interesting, correlation doesn’t equal causation. It stands to reason that investors in both instruments—Greek CDS and Greek bonds—both got spooked at the same time, driving up the cost of the former and driving down the cost of the latter. It’s hard to say whether CDS were the horse or the cart here, and the TImes shouldn’t imply it knows.

But that doesn’t mean it’s wrong for the Times to put this activity in the spotlight—far from it. The story shows the conflicts of interest rife in the CDS market. The piece’s point is logical: That CDS can be a self-fulfilling prophecy. It’s clear that bond investors have increasingly looked to the CDS market for signals, most famously in the waning days of the housing bubble when the indexes were created, allowing investors to bet against subprime asset-backed securities and the like.

And it has reporting that bolsters its case, like this:

“It’s like the tail wagging the dog,” said Markus Krygier, senior portfolio manager at Amundi Asset Management in London, which has $40 billion in global fixed-income assets. “There is a knock-on effect, as underlying positions begin to seem riskier, triggering risk models and forcing portfolio managers to sell Greek bonds.”

And this:

Such derivatives have assumed an outsize role in Europe’s debt crisis, as traders focus on their daily gyrations.

It’s a potential feedback loop, that’s for sure. And it’s always good to keep a close eye on CDS, which played a key role in causing the broader financial crisis in the first place.

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Ryan Chittum is a former Wall Street Journal reporter, and deputy editor of The Audit, CJR's business section. If you see notable business journalism, give him a heads-up at Follow him on Twitter at @ryanchittum.