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What? Sovereign Debt Edition

posted by Stephen Lubben

I'm sure our current guest blogger will have more to say about the current state of the sovereign debt markets, but I could not resist commenting on this rather confusing and odd article in today's FT about Goldman and Greece. Turns out part of the problem is that the article uncritically rehashes this letter from Representative Maloney, which is itself confusing and odd.

The key quote from both is this: "The increase in demand for insurance on government debt through credit default swaps harkens back to the activities that brought down American International Group." I'm not sure quite what this means, but the apparent analogy is flawed for several reasons. First, AIG was selling CDS with no real risk management, whereas Goldman is now buying CDS. Greece is neither buying nor selling CDS, although the article and letter might leave you with that impression. Second, while I've certainly argued that corporate CDS can generate perverse incentives to push a company into bankruptcy, I've also warned against the unthinking importation of corporate bankruptcy concepts into the sovereign debt world, and this analogy seems to be headed in that direction. Sovereigns -- at least at the national and state level -- can't be pushed into bankruptcy involuntarily, indeed they can't file for bankruptcy at all. That's an important difference that is often lost in the breathless commentary that the CDS markets will lead to a Greek/Icelandic/Portuguese/Californian "bankruptcy." Finally, I'm not sure why the "increase in demand" for sovereign CDS is itself anything to be concerned about -- other than what it suggests about the underlying problems with sovereign borrowers.

Indeed, I don't really understand the basis for the argument, made in the New York Times this week, that sovereign CDS will somehow push Greece to default, although I note that the AIG quote from FT and the Congresswoman could be charitably described as a restatement of the second paragraph of the NYT article. The Times article itself suffers from the sovereign/corporate confusion I discuss above.

At heart, the FT article (along with the Congresswoman's letter) seems like a rather feeble effort to link the present problems regarding Greece to the new easy target for all financial reformers:  CDS.

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