Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman

Why Markets Need 'Naked' Credit Default Swaps. By Stuart M Turnbull and Lee M Wakeman
Anyone facing losses from a government default should be able to protect himself by hedging.WSJ, September 11, 2012, 7:22 p.m. ET
http://online.wsj.com/article/SB10000872396390443686004577639753399337204.html

Many regulators, politicians and academics consider credit default swaps to be insurance contracts. These folks then use the insurable-interest rule—which limits life-insurance claims to individuals adversely affected by the death of the insured—to recommend banning "naked" CDS purchases, that is, buying sovereign credit default swaps without holding the underlying sovereign bond. Financial Times columnist Wolfgang Munchau, for example, says that a naked CDS has "not one social or economic benefit."

The premise that only sovereign-debt holders suffer when a country defaults is false. Many other agents are adversely affected by a default, and they should be allowed to purchase sovereign CDS.

A 2006 Bank of England study found that the output losses for 45 sovereign defaults between 1970 and 2000 "appear to be very large—around 7% a year on the median measure—as well as long lasting." The haircut taken by investors after sovereign defaults ranges from 20%-70%. But many spectators to a sovereign-default drama also suffer significant losses of wealth and livelihood.

Domestic importers and foreign exporters suffer when the default is accompanied by a devaluation. Financial institutions and holders of domestic corporate debt suffer as their asset values fall. Domestic companies suffer as their credit risk increases, with smaller businesses being especially harmed as banks reduce loan availability. And of course all consumers suffer as the economy retrenches.

In Mexico after its 1982 default, new lending dried up, trade suffered, incomes dropped and economic growth stagnated. In Russia after its 1998 default, food prices doubled, input prices quadrupled and many banks collapsed. In Argentina after its 2002 default, inflation touched 80%, unemployment rose to 25%, the peso lost 70% of its value, bank credit was halved and many businesses closed.

Today, many participants in the Greek, Irish, Italian, Portuguese and Spanish economies suffer as their governments struggle to prevent bank runs and avoid default. Millions of Europeans will undoubtedly lose wealth and work if defaults are not avoided.

If one or more of these sovereigns do default, there will also be serious consequences for participants in other linked markets. Commercial banks will suffer losses on the defaulted debt, possibly triggering bank runs if investors fear they will be unable to honor their commitments.

Many other foreign participants will also suffer, as contagion concerns cause investors to downgrade many assets, including sovereign and corporate debt, and to demand increased collateral. This in turn may force the selling of distressed assets, pushing prices even lower.

While there are other ways of insuring against corporate defaults—shorting stocks or buying put options, for instance—credit default swaps provide the only cost-effective way of hedging against sovereign defaults.

Rather than restricting access to the sovereign debt CDS market, regulators should encourage the introduction of standardized, exchange-traded "mini" sovereign debt CDS contracts, which would allow small buyers to better protect themselves against default.

There is also little evidence to support the argument that access to the sovereign CDS market should be restricted because of excessive speculation. Although credit default swaps written on Greek government bonds paid out a relatively high 78.5 cents on the dollar in March 2012, the owners of these swaps only received $2.5 billion—a small fraction of the $140 billion losses suffered when Greece defaulted.

Rather than destabilizing the market for euro-zone sovereign debt, credit default swaps, by providing a mechanism to shift risk, grow the market and reduce government financing costs.

In addition, CDS prices are useful signals of sovereign credit worthiness—which may explain the hostility of some politicians toward them.

Mr. Turnbull is a business professor at the University of Houston. Mr. Wakeman is a consultant at Risk Analysis & Control.