Editor’s note: This article was first published in July 2011, during the European sovereign debt crisis. The references to Greece’s rising borrowing costs, the risk to Italy and Spain, and European calls to regulate CDS and investigate investment banks describe that moment; later regulatory changes are not reflected.
In a previous article we explained what CDS are: credit default swaps, an investment vehicle that in some ways helped bring about the global crisis we are now living through. Some people said that in the future we would learn to recognize bubbles and wouldn’t make the same mistakes again. Well, that’s not true. We fell once and the market collapsed. Now we’re on the way to wiping out the markets altogether.
The big speculators want to get their slice out of this crisis once again, so now the investment takes the form of a bet against the market.
“If the house is going to burn down, let’s make money selling the furniture.”
When someone expects a stock to fall, they take a short position (selling shares in order to buy them back later at a lower price). That pushes the market down even further. On top of that, the CDS investor has a particular interest in seeing the market fall.
Warren Buffett described this instrument as financial weapons of mass destruction because, just as in Bush’s search for WMDs, nobody knows where these products are or who holds them. Unlike WMDs, of course, we know for certain that CDS exist: nobody knows how many there are, who holds them or exactly where they are, but they’re out there. The irony is that a CDS is a contract that insures against a default, and yet CDS are bought even by people who don’t hold the debt they’re supposedly insuring.
To some extent this has driven up the cost of financing for Greece, and we know the rest: all of Europe has been put at risk, Italy and Spain in particular.
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European authorities are calling for more regulation of this kind of product. They want investment banks investigated to see what part they are playing in this new stage of the crisis, although, as usual, it is denied that anyone is profiting from these products, and the idea that they are helping to destroy the markets is, of course, called into question.
In a nutshell: in the current state of European markets, it pays far more to invest in the disease than in the cure. History repeats itself. They know they will once again create an economic situation that can’t be sustained over time, but they also know that by the time that happens they’ll come out ahead again, because even today they’re profiting from the troubles of countries with serious debt problems. Far from helping, what’s actually happening is that the interest on that debt keeps getting more expensive, so we’ll probably see a new debt bubble. How much more expensive can the debt get, and how long will it take them to realize that, at such high interest rates, it probably can’t be repaid in the future?
Perhaps someone should step forward and admit that no market analyst knows how we can get out of this. CDS can be tracked at the moment they’re bought, but once they’re bundled into another investment vehicle and that phantom product ends up trading on the stock market, they turn into air and poison. You’re investing in a product that, you could say, “doesn’t exist”, while at the same time it sits inside the lymphatic system of the markets, poisoning them little by little.
I didn’t study at Harvard, but I know enough to see that a few people are once again hurting a great many others and nobody is doing anything to stop it. When this is over, we’ll all end up paying for it again, and this time at a much higher price.
Further reading
Featured image: Serge Vergouwe, CC BY-SA 3.0, via Wikimedia Commons.
