When Greece raised 5 billion euros (nearly $7 billion) in the bond market earlier this month, it had to offer investors an interest rate of 6.25 percent — nearly double what fellow European Union member Germany pays to borrow money.
The difference is that the Greek government’s finances are, as we noted here months ago, a train wreck, while Germany is still a good credit risk. The perilous state of Greek finances is made painfully clear every day in the financial markets where traders bet on the risk that various governments will default on their debts. Those bets are running heavily against Athens.
Greece has taken a few steps to try to get its financial house in order. But this process takes time and is unpopular with citizens who can expect to see their taxes raised (or at least more faithfully collected) and their government salaries and benefits cut. So Greece’s Prime Minister George Papandreou wants further action — not to fix his country’s finances, but to prevent skeptics from voicing their doubts in the marketplace.
Papandreou recently met with European leaders and with U.S. President Barack Obama to try to convince them that many of the bets being made against his country should be outlawed.
So far, Papandreou has found a lot of support. After she met with Papandreou, German Chancellor Angela Merkel told reporters, “We must succeed at putting a stop to the speculators' game with sovereign states.” Jose Manuel Barroso, president of the European Commission, the European Union's executive arm, said the commission would consider banning certain types of speculative trades. Papandreou said he also “found a very positive response” from Obama.
The specific financial instruments under fire are credit-default swaps, particularly so-called “naked” swaps. The types of investments that most people tend to be familiar with, such as stocks and bonds, involve betting that a company or government will do well. A credit default swap (CDS), on the other hand, allows an investor to bet that a certain bond issuer will do poorly and will not be able to meet its obligations. The CDS functions as a form of insurance against default. If you buy a bond and the borrower defaults, the CDS seller is obliged to cover your loss.
However, you do not need to actually own bonds from a borrower in order to purchase a CDS contract. Buying a CDS contract without any personal stake in the bonds it insures is known as making a “naked” wager. It is essentially a bet that the borrower will default or that the borrower’s risk of defaulting will go up, increasing the value of the CDS contract.
Greece and the other countries that are financially entangled with it through their shared use of the euro are not happy about these bets. “Credit default swaps, where you insure your neighbor's house just to destroy it and make money from it, that's exactly what we have to curb,” said Merkel.
But speculators’ poor opinion of Greece’s financial position is the result, not the cause, of its problems. “The concern over speculation is obscuring the underlying issue that Greece and other nations have very precarious fiscal positions,” said Simon Tilford, chief economist at the Center for European Reform. Mohamed El-Erian, chief executive of bond investment giant Pimco, said that, while speculative trades may amplify existing problems, they are “not major drivers.” European leaders who blame speculators are like players on a bad baseball team who blame the umpires, the scorekeeper and the jeering fans for their losing record.
Restricting CDS trades could actually result in higher borrowing costs for troubled countries. If CDS contracts are limited, investors will have less available protection from defaults and may require higher interest rates to offset the added risk. The Wall Street Journal noted that, on the day of Papandreou’s meeting with Obama, the cost of CDS protection on Greek, Italian, Portuguese and Spanish debt rose, possibly due to fears about the future availability of the swaps.
There are real problems with credit swaps — particularly the risk that issuers may make commitments far larger than they could ever keep, which is what nearly destroyed AIG. But problems with some traders do not invalidate the need for the trade. Investments always involve risk. Swaps allow the financial markets to measure risk and move it to investors who are willing to accept it. This allocation of risk is one of the greatest benefits of a free market.
Traders who put their own money on the line have every reason to call ‘em like they see ‘em. Kicking the umpires out of the game is not going to make Papandreou’s team play any better.
Larry M. Elkin is the founder and president of Palisades Hudson, and is based out of Palisades Hudson’s Fort Lauderdale, Florida headquarters. He wrote several of the chapters in the firm’s recently updated book,
The High Achiever’s Guide To Wealth. His contributions include Chapter 1, “Anyone Can Achieve Wealth,” and Chapter 19, “Assisting Aging Parents.” Larry was also among the authors of the firm’s previous book
Looking Ahead: Life, Family, Wealth and Business After 55.
Posted by Larry M. Elkin, CPA, CFP®
When Greece raised 5 billion euros (nearly $7 billion) in the bond market earlier this month, it had to offer investors an interest rate of 6.25 percent — nearly double what fellow European Union member Germany pays to borrow money.
The difference is that the Greek government’s finances are, as we noted here months ago, a train wreck, while Germany is still a good credit risk. The perilous state of Greek finances is made painfully clear every day in the financial markets where traders bet on the risk that various governments will default on their debts. Those bets are running heavily against Athens.
Greece has taken a few steps to try to get its financial house in order. But this process takes time and is unpopular with citizens who can expect to see their taxes raised (or at least more faithfully collected) and their government salaries and benefits cut. So Greece’s Prime Minister George Papandreou wants further action — not to fix his country’s finances, but to prevent skeptics from voicing their doubts in the marketplace.
Papandreou recently met with European leaders and with U.S. President Barack Obama to try to convince them that many of the bets being made against his country should be outlawed.
So far, Papandreou has found a lot of support. After she met with Papandreou, German Chancellor Angela Merkel told reporters, “We must succeed at putting a stop to the speculators' game with sovereign states.” Jose Manuel Barroso, president of the European Commission, the European Union's executive arm, said the commission would consider banning certain types of speculative trades. Papandreou said he also “found a very positive response” from Obama.
The specific financial instruments under fire are credit-default swaps, particularly so-called “naked” swaps. The types of investments that most people tend to be familiar with, such as stocks and bonds, involve betting that a company or government will do well. A credit default swap (CDS), on the other hand, allows an investor to bet that a certain bond issuer will do poorly and will not be able to meet its obligations. The CDS functions as a form of insurance against default. If you buy a bond and the borrower defaults, the CDS seller is obliged to cover your loss.
However, you do not need to actually own bonds from a borrower in order to purchase a CDS contract. Buying a CDS contract without any personal stake in the bonds it insures is known as making a “naked” wager. It is essentially a bet that the borrower will default or that the borrower’s risk of defaulting will go up, increasing the value of the CDS contract.
Greece and the other countries that are financially entangled with it through their shared use of the euro are not happy about these bets. “Credit default swaps, where you insure your neighbor's house just to destroy it and make money from it, that's exactly what we have to curb,” said Merkel.
But speculators’ poor opinion of Greece’s financial position is the result, not the cause, of its problems. “The concern over speculation is obscuring the underlying issue that Greece and other nations have very precarious fiscal positions,” said Simon Tilford, chief economist at the Center for European Reform. Mohamed El-Erian, chief executive of bond investment giant Pimco, said that, while speculative trades may amplify existing problems, they are “not major drivers.” European leaders who blame speculators are like players on a bad baseball team who blame the umpires, the scorekeeper and the jeering fans for their losing record.
Restricting CDS trades could actually result in higher borrowing costs for troubled countries. If CDS contracts are limited, investors will have less available protection from defaults and may require higher interest rates to offset the added risk. The Wall Street Journal noted that, on the day of Papandreou’s meeting with Obama, the cost of CDS protection on Greek, Italian, Portuguese and Spanish debt rose, possibly due to fears about the future availability of the swaps.
There are real problems with credit swaps — particularly the risk that issuers may make commitments far larger than they could ever keep, which is what nearly destroyed AIG. But problems with some traders do not invalidate the need for the trade. Investments always involve risk. Swaps allow the financial markets to measure risk and move it to investors who are willing to accept it. This allocation of risk is one of the greatest benefits of a free market.
Traders who put their own money on the line have every reason to call ‘em like they see ‘em. Kicking the umpires out of the game is not going to make Papandreou’s team play any better.
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