Rajiv Sethi Tue 2010-06-15 14:25 EDT
Defenders and Demonizers of Credit Default Swaps
The recent difficulties faced by Greece (and some other eurozone states) in rolling over their national debt has let some to blame hedge fund involvement in the market for credit default swaps...Leaving aside the question of whether naked CDS trading has been good or bad for Greece, it is worth asking whether there exist mechanisms through which such contracts can ever have destabilizing effects. I believe that they can, for reasons that Salmon and Jones would do well to consider...such contracts allow pessimists to leverage (much more so than they could if they were to short bonds instead). The resulting increase in the cost of borrowing, which will rise in tandem with higher CDS spreads, can make the difference between solvency and insolvency. And recognition of this process can tempt those who are not otherwise pessimistic to bet on default, as long as they are confident that enough of their peers will also do so. This clearly creates an incentive for coordinated manipulation...