Smith Faculty Opinion Article

By Dr. Peter Morici, Professor of International Business E-MAIL WEB SITE

March 10, 2010

Greece's Tragedy and Naked Swaps

It never ceases to amaze how political leaders can shamelessly blame free markets and faceless speculators for the consequences of their lousy financial decisions.

Front and center is Greek President George Papandreou blaming trading in derivatives for bringing down the house of cards that are Athens' national finances.

Credit default swaps are contracts bond holders purchase from large institutions, smaller funds or even individuals to obtain payment if interest or principal on bonds are not paid. Swaps are essentially insurance policies against default, much like casualty insurance against hurricanes, which spread risk.

Papandreou blames greedy speculators, who purchased swaps without actually holding bonds, so-called naked swaps for driving up Greek borrowing costs and pushing his government into its present desperate state. Of course, running a deficit exceeding 13 percent of GDP and extravagant public pensions had nothing to do with it.

Empirical studies of the Greek debt crisis do not indicate borrowing costs were much lifted by swaps, naked or clothed. Swaps written against Greek debt come to less three percent of Greece's $400 billion in outstanding debt.

Now, Papandreou, instead of adequately addressing Athens' overspending-he proposes to cut his deficit to paltry 9 percent of GDP-is lobbying a sympathetic President Obama for strict regulations on swaps. The EU Commission is examining an outright ban on "purely speculative" swaps.

For many debt securities, the scope of potential buyers of swaps is not large-after all holders of specific Greek bonds, state and municipal bonds, or groups of similar collateralized debt obligations that seek insurance are not large. Widening the market to include speculators-purchasers of naked swaps-leads to better price discovery through broader market assessment of the underlying risk of default.

The Greeks might not like the markets' assessment of Athens' finances, but looking at their national budget and the accounting mechanisms and financial instruments the Greek government used to disguise its plight during months prior to the crisis, it is hard to say speculators did the bond market, investors or the Greek people a disservice.

In the recent financial crisis, the problems were not naked swaps. Rather firms like Lehman Brothers had huge, inadequately-diversified or inadequately-insured positions on low quality mortgage-backed securities. And, sellers of swaps did not have adequate resources to back up what were essentially insurance policies against broad swings in market prices for underlying assets.

Proper regulation of derivatives markets is an important element of financial market reform, but the emphasis should be placed on ensuring that financial firms have adequate capital and diversified portfolios, and those that write swaps, back up their promises to pay with sufficient financial collateral.

This is what regulators require for property and casualty insurance companies.

Greek President Papandreou should focus on the political problems of persuading Greeks to accept what their government can afford instead of blaming investors for discovering Athens was, and still is, borrowing at unsustainable pace.

President Obama might do well to follow suit, lest the next Greek tragedy be played out closer to home.

Peter Morici is a professor at the University of Maryland School of Business and former Chief Economist at the U.S. International Trade Commission.