The Default Line: THE INSIDE STORY OF PEOPLE, BANKS AND ENTIRE NATIONS ON THE EDGE (8 page)

At the midtown New York offices of capital markets investment bank Cantor Fitzgerald, one of America’s busiest bond trading floors, Brian Edmonds eyes banks of computer screens. Edmonds is the firm’s head of interest rates, and its star bond trader. It’s not just the economic data he’s interested in, but also the deluge of political dysfunction from Washington DC to Frankfurt and Athens. He deals in dollars, euros, yen – any currency that’s doled out by the billion-load to the world’s debtor nations, for a price. This and other trading floors like it are where capital markets trump capital cities. The total size of the global bond market is $78 trillion, and half of this comprises government bonds. The USA and Japan alone make up over half of the world’s outstanding government bonds. The markets are large and liquid, with thousands of global players constantly trading electronically.

It was August 2011 when I visited Cantor Fitzgerald. It was during a historically turbulent week, when the USA lost its AAA credit rating. Intriguingly, Washington and London were being treated far more kindly than Paris, Athens or Dublin. I asked Brian what the impact had been on US Treasury bonds. ‘Positive,’ he said. Would a European sovereign get the same treatment? ‘I don’t think so. In the USA we still have our own currency, and if you look at full faith and credit of the USA, we still have the ability to pay the debt.’ By 2011 US bond traders were a little more understanding of the deficits of their government than their predecessors had been in the 1980s and 1990s.

By the time of the crisis, James Carville’s reincarnation of choice would have moved from the large investment-bank bond trading floors to the smaller trade in credit default swaps (CDSs) at a small hedge fund. CDSs had become an instrument to take a view in debt markets that previously would have required buying and selling a bond. The prices and market insight from CDSs were very helpful for regulators and central banks as measures of market default risk – and they were more quantitative and timely than the rankings of the credit-rating agencies. At the same time, CDSs were, and are, on the face of it, an insane gambling machine, used for speculative attack on banks and nation-states. They were almost completely unregulated. They had only relatively recently become legal. Before the crisis, the presumption had been that government credit risk in the Eurozone did not exist. But CDSs provided the weapon – and dithering in Europe provided an opening – for US and UK speculators and traders to make a killing.

‘I can make profits of five to seven times the cash I put up,’ says a hedge fund trader with whom I spent a day. ‘It’s a much more attractive return than buying an actual bond. CDS is a leveraged product, that’s why it grew so much.’ While we talk, various titbits of European political news are dripping through on the financial newswires. Of particular interest is the meeting between the Cypriot president and Angela Merkel. The hedge fund’s principal is trying to work out how Cyprus will be treated by Germany, and its implications for the debts of the Cypriot government and its banks. It seems impossible to trade this information like one might trade inflation numbers or currencies. We also ponder how the hedge funds based on algorithmic computer-trading cope with having to decode Angela Merkel’s glaring smile.

In 2006 ‘The Big Short’ against American subprime mortgages made billions for the hedge-fund traders willing to take a negative view. By 2010–11 it was ‘The Epic Short’ – against the euro. The victims were not overextended financiers of exotic home loans, but the treasuries of proud Western nation-states. And the bet was again coming from the East Coast of the USA. Some of the same hedge funds that banked hundreds of millions of pounds from subprime were also in on these speculative attacks. But they were joined by more seasoned participants in sovereign-debt markets: the vulture funds that traditionally focused on Third World debt. I suggested to the principal of one vulture fund that the EU authorities were going to ban some forms of the trade. ‘Let them. We’ll just trade with counterparties in New York or Switzerland instead,’ he said.

By 2011, shorting the single currency was proving recurrently profitable. To be clear, traders were not actually shorting the euro. The wisdom in the markets was that shorting the euro in currency markets was far too risky. What if Greece and the other crisis nations were kicked out of the Eurozone, and the euro basically became a twenty-first-century Deutschmark? No, the way to get at this trade most efficiently and with maximum leverage is via the famous credit default swaps market.

The trader explains how the market and the trade works. Traders buy and sell protection against a bond defaulting for an annual fee measured in fractions of a per cent, or ‘basis points’. If I am worried about Greece defaulting, I buy protection, pay the fee, post some collateral, and no longer have to worry about a default. If Greece goes bust, the seller of the protection pays out in full the value of the bond, and then has to claim what scraps he can from the recovery process. Simple enough – in essence, it’s a form of insurance. If I want to play this as a speculative bet, rather than a service to hedge my default risks, this is also possible. It was being used perfectly legitimately to gain from the demise of the euro periphery. Here’s how to make your millions. Step 1: Buy CDS protection for, say, Greece defaulting when the risk was low, at say 300 basis points, or a 3 per cent premium. Step 2: Wait for some riots or an inconclusive election, which skyrockets the risk of Greece going bankrupt. Step 3: Sell the CDS contract back when the risk is high, the spread at 1000 basis points, or 10 per cent premium, at vast profit. Step 4: Repeat with other euro countries.

‘Even from a 100 basis points [1 per cent] move,’ a trader told me, ‘I could make $4 million profit from a trade that required $6 million cash collateral. To make that profit in the bond markets would have required $100 million cash.’

Much hinged on the amount of collateral your counterparty required. For a small hedge fund, the figure would be high, for an investment bank low. For American International Group (AIG) as we shall see in Chapter 6 (see
here
), it was, for a period, zero, which helped fuel the mania that would eventually fell it. Yes, this is the same famous CDS market that – through AIG Financial Products’ unbelievable trading activity in London – nearly threatened to bring down half of Europe’s banking system in 2008. It’s the same CDS market that George Soros had previously told me was ‘the sword of Damocles’ hanging over the market. ‘This is an enormous unregulated market,’ Soros told me, ‘45 trillion dollars, which is equal to the entire household wealth of the United States, five times the national debt, five times the capitalisation of the stock market. It’s an enormous amount of liabilities, and you don’t know if the counterparty is good for its commitment.’ And Soros was speaking some months before AIG collapsed into the hands of the US government in 2008. Still, with returns of 800 to 1000 per cent possible, the gambit proved irresistible.

Some senior bond-market participants believed that the very act of buying the insurance aggressively in markets that are less liquid than that of the underlying bonds actually contributed directly to the rise in interest rates paid on government bonds, and the sense of fear and panic. The market has at least an element of dangerous circularity.

Jim Rickards used to work for Long-Term Capital Management (LTCM), which went belly-up in 1998. He describes the Big Euro Short as a ‘piñata party’ in which hedge funds were hunting as a feral pack, snapping at the soft underbellies of Greece, Italy and Spain. And then they watched as the money dropped out. He worried that the practice has ‘national security implications’, in that these three countries are all important Nato allies of the USA. ‘They should ban credit default swaps completely,’ Rickards says. ‘If you want to take a view, take it in the bond market, do it with real money. I don’t think this CDS market serves any purpose at all. It’s dangerous in ways very few people understand.’ Specifically, it is the naked CDS, which are trades made by those with no actual interest in the underlying bonds, that he feels should be banned. He is not alone; so does the German government and the European Parliament. A useful analogy is this: why allow someone with no insurable interest to take out fire insurance on someone else’s house? It is an incentive to burn down that house. It does not even require actual pyromania, just an ability to increase the perceived risk of fire. So the CDS traders need not hold the matches – just being able to influence the feeling that firestarters are out there is sufficient. Three French economists, including Anne-Laure Delatte of the Rouen Business School, published a study in 2011 giving some empirical backing to the idea that ‘CDS became a bear market instrument to speculate against the deteriorating conditions of the sovereigns’. Traders confirmed that sometimes the conventional bond markets lagged behind the smaller, less liquid CDS market in ‘price discovery’. But the reverse was also true on occasion. Delatte’s study claimed statistical evidence for CDS setting the price in periods of high distress. The bond market functioned as primary price-setter only in ‘core-European countries during calm periods’.

In the USA, ‘naked CDS’ were illegal under anti-gambling laws until the US Commodity Futures Modernisation Act of 2000, which gave the product specific exemptions. This was one of the last legislative acts of Bill Clinton in the White House. The act also created the ‘Enron loophole’, which collapsed the energy giant in a mire of corruption. The act was passed after the findings of a taskforce that included Alan Greenspan of the Federal Reserve and Treasury Secretary Larry Summers, whose aim was to block an effort by the commodities regulator to rein in derivatives. Even the intervening LTCM debacle failed to stop the race for derivative deregulation.

The case against CDS and naked CDS is clearly mixed. German regulators did not find they had a key role in Greece’s demise. Obviously these bets are only possible because of fiscal excess, because the crisis nations could not print their own money, and because Germany dithered over a longer-term solution. The market clearly gives some price signals. A former Lehman Brothers bond trader called Larry McDonald told me in the middle of the euro crisis that ‘It actually costs less to insure Panama than France. Kazakhstan traded inside of Italy. In other words the markets were betting that Kazakhstan was a safer bet than Italy and Spain. It’s absolutely insane.’ But was France really more of a risk than Panama, as CDS markets declared during the crisis? And Kazakhstan versus Spain? It seemed crazy.

In November 2012, against the advice of the IMF, the City and Wall Street, the EU banned naked CDS trades on European sovereigns. Hedge funds had to be prepared to declare the other trading interest that they were hedging when buying sovereign CDS. If you were shorting Italy by selling its sovereign CDS for example, you would have to be able to show that you owned a connected security, say an Italian corporate bond. Many of the traders simply gave up. The ban happened to coincide with Mario Draghi’s ‘bazooka’ of autumn 2012 (see
here
). Euro sovereign bond markets and their derivatives experienced a prolonged period of calm. However, traders said that if they wanted to ‘take a view’ they would simply short, say, an Italian bank instead, or some other institution not covered by the ban.

So these were the new bond vigilantes, with a powerful new instrument. The credit default swap reappears in various guises throughout this global tale of excess. On the one hand it was a barometer of credit excess where credit-ratings agencies failed, for example in Iceland. On the other it was part of the machine that fuelled that excess, decapitalised banking systems and helped bring about quite a few of the large financial bankruptcies.

Even George Osborne has taken to quoting various positive CDS numbers for Britain, boasting when it dipped below Germany. In 2008 the Conservatives, then in Opposition, had also pointed out that in 2008 the CDS market rated the UK sovereign as a riskier bet than the burger chain McDonald’s. Bond vigilantism in the twenty-first century was a far cry from its roots in the 1980s.

In April 2010 a weary Gordon Brown chose the not-yet-opened Queen Elizabeth Hospital in Birmingham to launch Labour’s election manifesto. With its thirty operating theatres, the largest critical care unit in Europe and a helipad for the war-wounded, the new hospital was a tangible reminder of the difference thirteen years of New Labour had made to the country. The Queen Elizabeth was a monument to the power of public-sector investment in healthcare. Except no voter had paid even a penny for this wonderful new facility, which had been financed entirely through the private finance initiative (PFI). But, even though it had cost the voters of Britain nothing, in years to come their grandchildren would still be paying for it.

The Queen Elizabeth Hospital opened its doors to patients some months later, under the coalition government, in the week of George Osborne’s emergency Budget, detailing spending cuts and tax rises to rein in a deficit that had reached a peacetime record. Yet the hospital, and hundreds of PFI projects like it, weren’t even part of the deficit numbers. PFI means that a hospital that is worth £627 million will cost a stream of payments starting at just under £50 million per year in 2010–11, going up in cash terms every year for thirty-eight years, peaking at £116 million in 2045–46, with the last payment not made until 2048–49. This means that, over the next four decades, taxpayers will have paid a total of £2.725 billion in cash terms, or about £1.221 billion in real terms, for a hospital with a capital value of £627 million.

PFI was conceived on the basis that the private sector could build more cheaply than the public sector, but it could not borrow as cheaply even at the time the scheme was dreamed up. Now, with borrowing costs for the UK at, or sometimes below, 2 per cent, versus PFI costs of 8 per cent, it is scandalously untrue. Originally developed in a limited manner under John Major’s government, PFI was propagated as a means of getting round Gordon Brown’s tough limits on investment spending in 1998–99. In the manner of Enron, the borrowing would be off-balance sheet. And so PFI was hugely expanded, and the extra cost above what it would cost from conventional exchequer funding was justified on the grounds that the NHS, schools and other public-project PFIs would receive decades of cleaning, upgrades and maintenance. But then various stories emerged of the £963 charged by a PFI contractor for a TV aerial, and the £875 for a £40 Christmas tree at HM Treasury, and the 65p light bulb charged out at £22. The Royal Institute for British Architects and the Audit Commission found no evidence for better design in PFI hospitals and schools.