Free The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE by Faisal Islam Page B

amount of liabilities, and you don’t know if the counterparty is good for its commitment.’ And Soros was speaking some months before AIG collapsed into the hands of the US government in 2008. Still, with returns of 800 to 1000 per cent possible, the gambit proved irresistible.
    Some senior bond-market participants believed that the very act of buying the insurance aggressively in markets that are less liquid than that of the underlying bonds actually contributed directly to the rise in interest rates paid on government bonds, and the sense of fear and panic. The market has at least an element of dangerous circularity.
    Jim Rickards used to work for Long-Term Capital Management (LTCM), which went belly-up in 1998. He describes the Big Euro Short as a ‘piñata party’ in which hedge funds were hunting as a feral pack, snapping at the soft underbellies of Greece, Italy and Spain. And then they watched as the money dropped out. He worried that the practice has ‘national security implications’, in that these three countries are all important Nato allies of the USA. ‘They should ban credit default swaps completely,’ Rickards says. ‘If you want to take a view, take it in the bond market, do it with real money. I don’t think this CDS market serves any purpose at all. It’s dangerous in ways very few people understand.’ Specifically, it is the naked CDS, which are trades made by those with no actual interest in the underlying bonds, that he feels should be banned. He is not alone; so does the German government and the European Parliament. A useful analogy is this: why allow someone with no insurable interest to take out fire insurance on someone else’s house? It is an incentive to burn down that house. It does not even require actual pyromania, just an ability to increase the perceived risk of fire. So the CDS traders need not hold the matches – just being able to influence the feeling that firestarters are out there is sufficient. Three French economists, including Anne-Laure Delatte of the Rouen Business School, published a study in 2011 giving some empirical backing to the idea that ‘CDS became a bear market instrument to speculate against the deteriorating conditions of the sovereigns’. Traders confirmed that sometimes the conventional bond markets lagged behind the smaller, less liquid CDS market in ‘price discovery’. But the reverse was also true on occasion. Delatte’s study claimed statistical evidence for CDS setting the price in periods of high distress. The bond market functioned as primary price-setter only in ‘core-European countries during calm periods’.
    In the USA, ‘naked CDS’ were illegal under anti-gambling laws until the US Commodity Futures Modernisation Act of 2000, which gave the product specific exemptions. This was one of the last legislative acts of Bill Clinton in the White House. The act also created the ‘Enron loophole’, which collapsed the energy giant in a mire of corruption. The act was passed after the findings of a taskforce that included Alan Greenspan of the Federal Reserve and Treasury Secretary Larry Summers, whose aim was to block an effort by the commodities regulator to rein in derivatives. Even the intervening LTCM debacle failed to stop the race for derivative deregulation.
    The case against CDS and naked CDS is clearly mixed. German regulators did not find they had a key role in Greece’s demise. Obviously these bets are only possible because of fiscal excess, because the crisis nations could not print their own money, and because Germany dithered over a longer-term solution. The market clearly gives some price signals. A former Lehman Brothers bond trader called Larry McDonald told me in the middle of the euro crisis that ‘It actually costs less to insure Panama than France. Kazakhstan traded inside of Italy. In other words the markets were betting that Kazakhstan was a safer bet than Italy and Spain. It’s absolutely insane.’ But was