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Europe is in a mess, but financial markets are probably making things worse..

February 12th, 2010 · 1 Comment

Financial markets give people incentives (and means) for things to get worse. This is just plain wrong…

It’s also a prime example of how unregulated (or badly regulated) financial markets suit Wall Street, but not necessarily main-street.

From the Financial Times:
How markets attacked the Greek piñata
By James Rickards

Published: February 11 2010 19:48 | Last updated: February 11 2010 19:48

Wall Street loves a piñata party – singling out a company or country, making it the piñata, grabbing their sticks and banging it until it breaks. As in the child’s game, the piñata is left in shreds. Unlike the child’s game, in the Wall Street version the piñata is stuffed with money for the bankers to scoop up with both hands, instead of sweets. We see this game being played today, with Greece as the piñata.

Investors trying to understand why their portfolios have begun to melt down for the second time in five years are becoming experts in the fiscal policy of Greece. A look at the piñata party might make things clearer.

Greece’s travails are often measured by reference to the market in credit default swaps (CDS), a kind of insurance against default by Greece. As with any insurance, greater risks entail higher prices to buy the protection. But what happens if the price of insurance is no longer anchored to the underlying risk?

When we look behind CDS prices, we don’t see an objective measure of the public finances of Greece, but something very different. Sellers are typically pension funds looking to earn an “insurance” premium and buyers are often hedge funds looking to make a quick turn. In the middle you have Goldman Sachs or another large bank booking a fat spread.

Now the piñata party begins. Banks grab their sticks and start pounding thinly traded Greek bonds and pushing out the spread between Greek and the benchmark German CDS price. Step two is a call on the pension funds to put up more margin, or security, as the price has moved in favour of the buyer. The margin money is shovelled to the hedge funds, which enjoy the cash and paper profits and the 20 per cent performance fees that follow. How convenient when this happens in December in time for the annual accounts, as was recently the case. This dynamic of pushing out spreads and calling in margin is the same one that played out at Long-Term Capital Management in 1998 and AIG in 2008 and it is happening again, this time in Europe.

Eventually the money flow will be reversed, when a bail-out is announced, but in the meantime pension funds earn premium, banks earn spreads, hedge funds earn fees and everyone’s a winner – except the hapless hedge fund investors, who suffer the fees on fleeting performance, and the unfortunate inhabitants of the piñata. What does any of this have to do with Greece? Very little. It is not much more than a floating craps game in an alley off Wall Street.

This is where the idea of CDS as insurance breaks down. For over 250 years, insurance markets have required buyers to have an insurable interest; another name for skin in the game. Your neighbour cannot buy insurance on your house because they have no insurable interest in it. Such insurance is considered unhealthy because it would cause the neighbour to want your house to burn down – and maybe even light the match.

When the CDS market started in the 1990s the whiz-kid inventors neglected the concept of insurable interest. Anyone could bet on anything, creating a perverse wish for the failure of companies and countries by those holding side bets but having no interest in the underlying bonds or enterprises. We have given Wall Street huge incentives to burn down your house.

Let’s be clear, public finance in Greece is a mess. Statistics have been fudged, government pensions have been inflated and reckless borrowing has been the norm. Drastic remedies are required. But the crisis is manageable, and Europe has sent clear signals that they will take care of their own house without help from China, America or the International Monetary Fund. Unfortunately, a measured response does no good to the dealers in CDS, who require volatility and even panic to make their game a profitable one. If contagion spreads in uncontrollable ways, so much the better for the traders in volatility, never mind the collateral damage.

Until the CDS market is confined to buyers who have an underlying interest in the risk being covered, and sellers who are regulated as insurance companies with adequate reserves, this market will remain a reckless enterprise bent on arson. Serious issues of sovereignty and stability are at stake. Regulators have to stop ignoring the piñata party and start providing adult supervision.

The writer is a director of Omnis and former general counsel of Long-Term Capital Management

Tags: Credit Crisis · Public Policy · Reform Capitalism

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