Greek Prime Minister George Papandreou has been making the case that sovereign CDS are at least partly to blame for his country sinking deeper and deeper into debt. This is because the financial markets have responded to a surge in the purchase of Greek sovereign CDS by raising the interest rates Greece pays on bonds it issues to raise money. These rates, set through public auctions, are currently about 6% or approximately double what the EU’s largest economy, Germany, pays.

The Greek rate is higher because the markets perceive that the risk of Greece defaulting on payments is higher. Normally, it is cheaper for governments to borrow money than for it is for companies because the default risk is lower. Unlike a company, which if its revenues fall may no longer be able pay its debts, a government has the option of levying new taxes on its citizens to raise more revenue. But Greece is an exception to this rule of governments enjoying lower interest rates because of the chronically poor state of its public finances.

Many argue that this, rather than greedy, reckless speculators, is the core problem. According to Desmond Lachman, an economic trends analyst at the American Enterprise Institute (AEI), a conservative think-tank in Washington, «the CDS have put pressure on Greece by drawing attention to the problem. But they are not responsible for creating it.» Lachman noted that Greece’s debt was US$400 billion, whereas the total value of sovereign CDS on Greece was just US$9 bn. He added, however, that «regulators have a point in objecting to ‘naked’ CDS selling [i.e. where the buyer does not own the underlying bond]. If a party does not have an insurable interest it does not make sense to be buying a CDS.» But even if naked selling was exacerbating the problem, Lachman felt «in the long-run, it will not make much difference. The real issue is Greece’s debt.» In 2009 Greece’s current account deficit soared to 12.7% of its Gross Domestic Product (GDP), while its long-term debt was 120% of GDP. This debt is a consequence of chronic high spending on the public sector and pensions, coupled with the autumn 2008 financial sector crisis that triggered a severe economic recession across the globe.

The association representing the derivatives industry, the International Swaps and Derivatives Association (ISDA), defends the use of CDS. The ISDA claims the Greek CDS were «useful for controlling risk for investors and lenders.» Even parties that do not hold Greek government bonds can have a legitimate interest buying Greek CDS, the ISDA argues, if they have invested in Greek banks, companies or stocks, all of which would be in serious trouble were the Greek government to default. And given that Greece is in the eurozone, a default could have a negative financial impact for anyone with investments in the euro area, the ISDA claims. It has published a table showing how trade in Greek CDS is at a comparable level to CDS taken out on other EU countries: US$26 bn on Italy, US$16 bn on Spain, US$13 bn on Germany and US$9 bn on France.

One industry analyst doubted there really was as much speculative CDS trading as some have suggested. «It is too big a gamble to take. If the country does not default you lose all your money,» the analyst said. Moreover, the cost of buying Greek CDS has rocketed as Greece’s creditworthiness has slumped. In 2007 it cost US$5,000 to insure US$10 million of Greek debt, whereas by 2010 it cost US$425,000. With interest rates on Greek government bonds now 6%, continuing to lend the Greek government money may be a more lucrative proposition than insuring against it defaulting. One analyst noted how another EU country with a big budget deficit, Ireland, has not experienced as much speculative CDS trading. The reason, they said, was that Ireland has historically not been in debt for as long as Greece and was making more drastic spending cuts than Athens had done so far.

A separate but related aspect of the Greek debt crisis concerns the role of US investment bank Goldman Sachs in converting some of Greece’s debt into a derivatives contract allegedly sold on the market to mask the extent of Greece’s debt. The US Federal Reserve and Securities and Exchange Commission are investigating this matter. Federal Reserve Chair Ben Bernanke told a US Senate hearing, on 25 February, that «credit default swaps are properly used as hedging instruments,» adding that «using them in a way that intentionally destabilizes a company or a country is counterproductive.» The transaction occurred when Greece was trying to show that its finances were sufficiently sound to be part of the eurozone.

TO DEFAULT OR NOT TO DEFAULT

The great unanswered question, of course, is will Greece actually default? During a panel discussion at the AEI, on 22 March, experts were divided. Jacob Kirkegaard from the Peterson Institute for International Economics and Georges Pineau from the European Central Bank thought it unlikely. But the AEI’s Lachman was less sure, noting that as Greece began slashing public spending as required, its long-term debt ratio would increase because Greek GDP, the denominator against which the US$400 bn debt is measured, would decline. Carmen Reinhart, economics professor at the University of Maryland, predicted that Greece would eventually default, based on its bad track record. She noted how since becoming an independent country in 1829, Greece had been in default for 50% of the time.

 «Since becoming an independent country in 1829, Greece has been in default for 50% of the time» 

Net notional amount of Greek CDS:*

March 2009: US$7.4 billion

1 January 2010: US$8.7 bn

March 2010: US$9.2 bn 

*Maximum possible net fund transfers between sellers and buyers(1) Source: ISDA