How credit default swaps will have destroyed the Euro

12 juin 2012 par Paul Jorion

And what of the CDS (credit-default swap) speculators who don’t pay taxes? Why don’t we hear anything about them? We hear a lot about the Greeks not paying their taxes, and at the moment, due to the tactlessness of some, we hear a lot about international civil servants (more precisely those of the International Monetary Fund) who don’t pay taxes, but, in the case of CDS speculators who pay no taxes, goodness knows why – not a word!

It has to be said that it is not so simple to find out who they are exactly because they constitute part of the shadow banking sector. Which is what exactly? It is non-regulated finance. Why is it non-regulated? Because it is these people who pay the salaries of the lobbyists who draft up the financial regulation laws (and sometimes other laws too), which the elected representatives then receive ready-made, and which only require signing-off.

Being in the shadows therefore, we don’t really know who they are. Do they never explain who they are? Well yes, in a way: when a speculator speaks on his behalf, he always employs the same expression: “people acting with due care and diligence”. When a speculator explains what he does, he starts his phrase with “people acting with due care and diligence ….” For the remainder of this article I shall therefore designate the speculators as “people acting with due care and diligence”, and it will be clear who I am talking about.

When the Greek collapse was imminent, people talked a lot about the responsibility of the CDS for what was happening. Now with regard to Spain, not a word! Why have people stopped talking about credit default swaps? I don’t know, unless it is as in the Jacques Brel song “On n’oublie rien de rien, on s’habitue, c’est tout” (We don’t forget anything about anything, we just get used to it, that’s all”)

How will Credit Default Swaps destroy the Euro? I will explain. First of all, a reminder that a CDS can play the role of insurance for a debt.  Imagine you have lent 100 € to Oscar. As you are not sure of being paid back, you address yourself to Eusèbe who insures you. Every month you pay 5 € to Eusèbe, and in return for this premium, Eusèbe will pay you any money that is missing at the end. Oscar only gives you 75 € back? Eusèbe will give you the missing 25€. Oscar has vanished into thin air? Eusèbe will pay you, on the dot, the missing 100 €.

That’s what is called a ‘covered’ CDS position. Now let’s turn to the ‘naked’, uncovered positions. Pay close attention, this time it’s more complicated because there are now four people involved: there is also Jules and Gontran. Jules has lent 100 € to Gontran. I visit Eusèbe and I ask him to insure me against the possibility of Gontran not paying Jules back. Why would I do that? For goodness sake! Because I am a person acting with due care and diligence of course (I swear, some people ask the strangest questions!)

I won’t explain why it has become normal to call a ‘naked’ CDS position: “insuring the neighbour’s car”, I’m sure you have understood.

Naked CDS positions will be forbidden in Europe from the month of November. Why have we waited so long given that these naked CDS positions had already led to the collapse of Greece in January 2010? (Here we go again, people asking the strangest of questions!) Because there was still Spain, Italy and France…. to be sent to the scrap yard, then to be sold on in bits at attractive prices to those prudent (forward-thinking) ‘people acting with due care and diligence’ who had put some money aside.

How do these people acting with due care and diligence cause the collapse of a country? Once again, I’ll be brief: they insure the neighbour’s country. As they are (at the least) four times more numerous than those who insure their own country (and who have really something to lose), they inflate swell the demand, leading to a rise in prices.

Meanwhile the economists watching all this say to each other : “Goodness, look how the risk that Gontran doesn’t pay Jules back is increasing. Scary stuff!”

Do the economists not understand then that it is those people acting with due care and diligence who cause the prices to rise? No. In their economy manuals, speculation doesn’t exist: it is not explained. If it is, there is a little footnote which describes how “people acting with due care and diligence contribute liquidity to the market”. End of story.

The price of the CDS premiums increases, because demand increases. The economists calculate the risk that the country won’t repay its debt by effecting a calculation in the opposite sense: from the amount of the CDS premium.

The result is that the day when Gontran presents himself again, in order to lend to him the capital markets require a rate of interest into which they have inserted (it’s called the spread in the newspapers) the risk premium for the CDS market (those genuinely insured people acting with due care and diligence) and, hey presto, to borrow over 10 years, Gontran is asked to pay an interest rate of 28.9% ( as is the case for Greece at the moment according to Bloomberg) and it’s all over for Gontran: the troika is already knocking at his door explaining how to become a serf, and how it’s not too bad after all.

But wait, it’s not yet over: the funniest is yet to come! An insurer has to have reserve funds, doesn’t it? In that way, if something unforeseen happens, it can draw on its reserves. In the majority of cases, this will be enough and if it is not the problem is posed only for the difference between the sum to be paid and the reserves, which will, at least, have softened the blow. But in the case of the CDS (and here I see some of you laughing your heads off because you can see what is coming) the CDS are in the shadow banking sector! What would be the point of being in the shadow banking sector, if in this shadow banking sector, one were obliged to keep reserves as one would in the (idiotic) daylight sector?

So, no reserves to cushion the blow in case of a problem, and as there is -as I have said – (at least) four times more people acting with due care and diligence who have insured their neighbour’s country than those who are really running a risk………

And this is why, to cut a long story short, CDS will destroy the Euro (or at least, it, given that, from the way in which it started…..)