Mar 8 2010, 9:51 AM ET
In order to believe that CDS are “shaking Europe”, you have to believe that when one market player buys sovereign credit protection off another market player, in a transaction both sides think they’re going to make money on, finance ministries across the continent start to tremble. It’s silly. Sovereign credit spreads have moved up and down in sometimes-dramatic fashion for decades, long before CDS were even invented. And they will continue to do so even if CDS are banned. And there’s no indication whatsoever that volatility in European credit spreads is any higher now than it would have been absent the CDS market. Indeed, there’s a colorable case that the opposite is true, and that the ability to hedge one’s exposure in the CDS market has made the European sovereign bond market less volatile.
As for the NYT’s idea of the “purpose” of a CDS, all I can say is that I have no idea whatsoever where they got that one from. At least on the CDS/Greece connection, you can see how various European politicians love to be able to blame Goldman Sachs rather than themselves for their woes. But this just makes no sense at all. What “complex debt securities”, exactly, can banks issue more easily if CDS reduce the risk to purchasers? Presumably we’re not talking about simple bonds and loans here, since they’re not complex at all. Is the idea that banks somehow help companies issue debt bundled with CDS insurance? I’ve seen a few monoline wraps in my time, but nothing like that
You see this sort of folk mythology among market watchers very frequently. They note that there are financial instruments which convey negative information about the soundness of the underlying institution. Furthermore, they quickly realize that just before institutions fail, there is often quite a lot of activity in those sorts of financial instruments. Therefore, if you could only eliminate the instruments, you could also eliminate the failures!