Bearish Raid on the PIGS?

Includes: EWP, FXE, IRL
by: Ira Stoll

"European CDS Spreads Widen" was the headline on a Wall Street Journal article yesterday morning about the cost of insuring against a default on bonds issued by Portugal, Ireland, Greece, and Spain. At the end of the article is this explanation:

CDS are tradable, over-the-counter derivatives that function like a default insurance contract for debt. If a borrower defaults, the protection buyer is paid compensation by the protection seller. Swap buyers may be protecting investments they own or simply making bearish bets against companies or countries.

It's one thing to buy protection on bonds that you hold. But it's another thing to buy it on bonds that you don't hold; that's kind of like buying fire insurance on a house you don't own. There's a big incentive to commit arson. It's similar in some ways to naked shorting, or selling stock that you don't own.

It's tempting in some ways for to call for regulators to ban the sale of default insurance to those who don't own the underlying debt. On the other hand, that's an interference on the right of contract. And the signals sent by CDS prices are useful market information that could become less reliable if the market were restricted.

As an alternative, regulators might require disclosure of the identities of CDS holders who don't hold the underlying debt, and then require the disclosure of any activities they undertake -- lobbying, talking to journalists and other investors -- that are intended to bring about a default or heighten fears of a default. The Wall Street Journal article, for example, quotes Gary Jenkins, head of fixed income research at Evolution Securities in London, as saying:

Thus far the situation regarding Greek debt has been stabilized by the EU talking of support rather than actually giving any direct financial assistance...The situation is still very uncertain.

Does Evolution Securities have a bet that Greece will default? Do its clients have such a bet? How big are those bets? It would be nice to know, wouldn't it?

I'm not saying there aren't any genuine underlying issues in the PIGS. Maybe journalists or those who are long PIGS debt can dig out this kind of information on their own. Markets often are not so easily manipulable as their critics think, especially over the long term. But if I were a high government official in Greece, I sure would like to know who is out there betting that I will default on my debt, and what they are doing to try to make sure they win that bet.