Interesting article from VoxEu on Credit Default Swaps. Reprinted here with permission.
The role of naked credit default swaps in the global crisis is an ongoing source of controversy. This column seeks to add some formal analysis to the debate. Its model finds that speculative side bets can have significant effects on economic fundamentals, including the terms of financing, the likelihood of default, and the scale and composition of investment expenditures.
There is arguably no class of financial transactions that has attracted more impassioned commentary over the past couple of years than naked credit default swaps. Robert Waldmann has equated such contracts with financial arson, Wolfgang Münchau with bank robberies, and Yves Smith with casino gambling. George Soros argues that they facilitate bear raids, as does Richard Portes (2010) who wants them banned altogether, and Willem Buiter considers them to be a prime example of harmful finance. In sharp contrast, John Carney believes that any attempt to prohibit such contracts would crush credit markets, Felix Salmon thinks that they benefit distressed debtors, and Sam Jones argues that they smooth out the cost of borrowing over time, thus reducing interest rate volatility.
One reason for the continuing controversy is that arguments for and against such contracts have been expressed informally, without the benefit of a common analytical framework within which the economic consequences of their use can be carefully examined. Since naked credit default swaps necessarily have a long and a short side and the aggregate payoff nets to zero, it is not immediately apparent why their existence should have any effect at all on the availability and terms of financing or the likelihood of default. And even if such effects do exist, it is not clear what form and direction they take, or the implications they have for the allocation of a society’s productive resources.
In a recent paper (Che and Sethi 2010), we have attempted to develop a framework within which such questions can be addressed and to provide some preliminary answers. We argue that the existence of naked credit default swaps has significant effects on the terms of financing, the likelihood of default, and the size and composition of investment expenditures. And we identify three mechanisms through which these broader consequences of speculative side bets arise: collateral effects, rollover risk, and project choice.
Heterogeneous beliefs and side bets
A fundamental (and somewhat unorthodox) assumption underlying our analysis is that the heterogeneity of investor beliefs about the future revenues of a borrower is due not simply to differences in information, but also to differences in the interpretation of information. Individuals receiving the same information can come to different judgments about the meaning of the data. They can therefore agree to disagree about the likelihood of default, interpreting such disagreement as arising from different models rather than different information. As in prior work by John Geanakoplos (2010) on the leverage cycle, this allows us to speak of a range of optimism among investors, where the most optimistic do not interpret the pessimism of others as being particularly informative. We believe that this kind of disagreement is a fundamental driver of speculation in the real world.
When credit default swaps are unavailable, the investors with the most optimistic beliefs about the future revenues of a borrower are natural lenders: they are the ones who will part with their funds on terms most favourable to the borrower. The interest rate then depends on the beliefs of the threshold investor, who in turn is determined by the size of the borrowing requirement. The larger the borrowing requirement, the more pessimistic this threshold investor will be (since the size of the group of lenders has to be larger in order for the borrowing requirement to be met). Those more optimistic than this investor will lend, while the rest find other uses for their cash.
Now consider the effects of allowing for naked credit default swaps. Those who are most pessimistic about the future prospects of the borrower will be inclined to buy naked protection, while those most optimistic will be willing to sell it. However, pessimists also need to worry about counterparty risk – if the optimists write too many contracts, they may be unable to meet their obligations in the event that a default does occur, an event that the pessimists consider to be likely. Hence the optimists have to support their positions with collateral, which they do by diverting funds that would have gone to borrowers in the absence of derivatives. The borrowing requirement must then be met by appealing to a different class of investors, who are neither so optimistic that they wish to sell protection, nor so pessimistic that they wish to buy it. The threshold investor is now clearly more pessimistic than in the absence of derivatives, and the terms of financing are accordingly shifted against the borrower. As a result, for any given borrowing requirement, the bond issue is larger and the price of bonds accordingly lower when investors are permitted to purchase naked credit default swaps.
This effect does not arise if credit default swaps can only be purchased by holders of the underlying security. In fact, it can be shown that allowing for only “covered” credit default swaps has much the same consequences as allowing optimists to buy debt on margin: it leads to higher bond prices, a smaller issue size for any given borrowing requirement, and a lower likelihood of eventual default. While optimists take a long position in the debt by selling such contracts, they facilitate the purchase of bonds by more pessimistic investors by absorbing much of the credit risk. In contrast with the case of naked credit default swaps, therefore, the terms of lending are shifted in favour of the borrower. The difference arises because pessimists can enter directional positions on default in one case but not the other.
Naked credit default swaps and self-fulfilling pessimism
While this simple model sheds some light on the manner in which the terms of financing can be affected by the availability of credit derivatives, it does not deal with one of the major objections to such contracts: the possibility of self-fulfilling bear raids. To address this issue it is necessary to allow for a mismatch between the maturity of debt and the life of the borrower. This raises the possibility that a borrower who is unable to meet contractual obligations because of a revenue shortfall can roll over the residual debt, thereby deferring payment into the future.
As many economists have previously observed, multiple self-fulfilling paths arise naturally in this setting (see, for instance, Calvo 1988, Cole and Kehoe 2000, and Cohen and Portes 2006). If investors are confident that debt can be rolled over in the future, they will accept lower rates of interest on current lending, which in turn implies reduced future obligations and allows the debt to be rolled over with greater ease. But if investors suspect that refinancing may not be available in certain states, they demand greater interest rates on current debt, resulting in larger future obligations and an inability to refinance if the revenue shortfall is large.
A key question then is the following: how does the availability of naked credit default swaps affect the range of borrowing requirements for which