Corporate & Securities Law

Credit derivatives don?t kill countries, politicians do

Looking for something to blame for the Greek debt crisis, some observers are pointing their fingers at credit derivatives. An article in yesterday?s New York Times makes the case that credit default swaps (CDS), and specifically their sale by Goldman Sachs, are somewhat to blame in part for Greece?s problems.

As I explain in this paper, credit derivatives are merely a financial tool that can be used by those exposed to credit risk, say a default by the Greek government or General Electric, to share that risk with others. This lowers the costs of borrowing and helps spread risk. In addition, third parties with no exposure to the particular credit risk can bet on whether the Greeks will default. These secondary-market transactions are the same as an individual buying stock in General Electric betting it will rise. Importantly, these bets provide a liquid market for credit risk, which lowers the cost of hedging for those with primary exposure, and provides the market with better information about whether Greece or General Electric is a good credit risk. Those who might lend to the country or company, those conducting other business with it, and those who might face the risk of default in other ways, can use this information to better plan their activities. For instance, those disbelieving a country or company?s claim of financial soundness, say because of funny accounting (think: Enron or, dare I say, America) can use credit derivatives to short debt, something that was impossible before credit derivatives were invented. This makes debt prices more accurate and holds borrowers, be they sovereigns or corporations, better to account.

Of course, there is the possibility for abuse. Another New York Times article from a few weeks ago highlights the possibility for abuse in this market. (Note the parallel between the conflict of interest across departments at Goldman Sachs and those in the investment analyst scandals from a few years ago.) But abuse is possible in all markets, and everyone should be in favor of vigorous enforcement against those who try to manipulate markets or trade on undisclosed conflicts of interest. The existence of the potential for abuse, however, is no more an indictment of credit derivatives generally than it is of the stock market or any other useful tool of society than can sometimes be abused.

It is the ultimate irony that politicians are blaming their problems on a tool that helps reveal their tricks and mistakes. This is akin to a burglar blaming an alarm system for being caught. Sure, the burglar might have been better off without it, but the homeowner and everyone else is glad it was installed.

Full post as published by Truth on the Market on March 11, 2010 (boomark / email).