Thursday, June 23, 2011

The ticking CDS time-bomb

The looming mess in Europe, linked to financial distress in Greece, looks like a perfect if rather frightening illustration of the malign consequences of over-dense banking interdependence on global financial stability. In this case -- as with the crisis of 2007-2008 -- the root cause of the trouble is CDSs and other derivatives. No one in Europe is quite sure how many reckless gambles banks have made over Greek debt and potential default, and the European Central Bank appears to be deadly afraid that such gambles have the potential to bring down the entire financial house of cards.

What's happened to the CDS market over the past decade? It's exploded. Amazingly, the value of outstanding CDS linked to debt in Greece, Italy, Spain and Portugal has doubled in the past three years -- since 2008!! The New York Times today discusses what can only be described as a ridiculous situation -- Europe pushed to the brink of a financial disaster by the actions of a small number of people gambling with other peoples' money in the dark, and doing so in the direct aftermath of the greatest financial crisis since the Great Depression:
The uncertainty, financial analysts say, has led European officials to push for a “voluntary” Greek bond financing solution that may sidestep a default, rather than the forced deals of other eras. “There’s not any clarity here because people don’t know,” said Christopher Whalen, editor of The Institutional Risk Analyst. “This is why the Europeans came up with this ridiculous deal, because they don’t know what’s out there. They are afraid of a default. The industry is still refusing to provide the disclosure needed to understand this. They’re holding us hostage. The Street doesn’t want you to see what they’ve written.”
 Wonderful. We've known about this danger for at least several years and have done nothing about it. But in fact, we've actually known about such danger for far longer, and have only taken steps to make our problems worse. A couple of years ago CBS aired an examination of the CDS market, and it is still worth watching. One interesting comment from the program:
It would have been illegal [selling CDSs of any kind] during most of the 20th century under the gaming laws, but in 2000, Congress gave Wall Street an exemption and it has turned out to be a very bad idea.

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