An interesting discussion going on in the blogosphere as Felix Salmon argues that credit default swaps aren’t to blame for Greece’s woes. Today he responds to Rajiv Sethi by citing the case of Brazil, circa 2002. Here’s what he says:
“Exhibit A, here, is Brazil, circa 2002, when the markets were terrified about Lula’s upcoming election, and refused to believe that he would follow market-friendly policies. They drove Brazil’s debt spreads up to 2,000bp over Treasuries — five times the worst levels that we’ve seen in Greece — and refused to lend Brazil any new money at any interest rate at all, at least not in dollars. Brazil was therefore facing a liquidity crisis much worse than anything the Greeks are going through right now: it had essentially no ability to roll over its debts as they came due. A default seemed inevitable, and was certainly more than priced in to the bond markets; while sovereign CDS on Brazil did exist at the time, the market was small and was never blamed for Brazil’s bond spreads.
Eventually, Brazil pushed through, never defaulted, and provided spectacular returns for fund managers who had bought near the lows. If spreads of 2,000bp over Treasuries didn’t turn into a self-fulfilling prophecy in Brazil, I don’t think that spreads of 400bp over Bunds are going to make default any more likely in Greece.”