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Europe has just eviscerated the sovereign CDS market

What happens when you get a default that equates to a 50% loss for most investors without triggering default insurance? Massively negative unintended consequences.

Europe has just made a mockery of the sovereign credit default swap (CDS) market by trying to structure a default via voluntary 50% haircuts in order to avoid triggering CDS claims. It makes absolutely no sense to act as if Greece is not defaulting here.

As I wrote earlier today:

In Greece, I find it odd that private sector creditors are invited to write down notional debt while the European Central Bank and the Troika are not. Clearly, the voluntary and private sector nature of this structure is necessary to at once avoid triggering credit default swaps, to assuage voter anxiety about taxpayer losses outside of Greece, and to protect the ECB from an explicit loss of capital which would render it technically insolvent.

All of these are legitimate aims. But the optics of this are poor and I am not at all convinced participation in the voluntary arrangement will be adequate to cut the debt burden enough to prevent a further ‘haircut’ down the line.

Bottom line: It’s a sham. And it will lead to either much higher bond yields or massive litigation or both. Choose your poison.

Reggie Middleton was on RT discussing this very issue. He has some very astute commentary. Take a look.

Also see: Greece Debt Swaps’ Failure to Trigger Casts Doubt on Market – Bloomberg

About 

Edward Harrison is the founder of Credit Writedowns and a former career diplomat, investment banker and technology executive with over twenty years of business experience. He is also a regular economic and financial commentator on BBC World News, CNBC Television, Business News Network, CBC, Fox Television and RT Television. He speaks six languages and reads another five, skills he uses to provide a more global perspective. Edward holds an MBA in Finance from Columbia University and a BA in Economics from Dartmouth College. Edward also writes a premium financial newsletter. Sign up here for a free trial.

20 Comments

  1. Econ Mav says:

    Fascinating stuff from Reggie. Just my guess, but I question how significantly the CDS market would directly affect the bond market? After all, the very people who own the bonds(the banks) are taking the haircut voluntarily or “voluntarily”, but either way, they certainly are not going to sue the CDS contract writers if they themselves are holding the insurance on the bonds they own. Perhaps 3rd party investors will either sue or dump the CDSs, but what kind of an effect would that have on the underlying bonds themselves? Perhaps it will have an effect, but i’m skeptical that it wouldn’t be very muted because they were not bond buyers to begin with.

    • David Lazarus says:

      My take is that if you are a bond holder that you effectively hedge any potential losses with a CDS, though losses through a change of interest rates would have to be covered by an interest rate swap. So if interest rates were stable at 3% then you would price the bond to get that 3% yield. If there was a default then you would be reimbursed by the swap writer. So your capital losses would be offset by the swap. If this was broken then the bond holder would have to be made whole some other way. My thought then comes to the re-capitalisation. Would banks walk away from being made whole? No. So the terms of the restructuring must be very generous. That would be that the banks will effectively be given several hundred billion euros without any penalties. Otherwise why take such losses without some other payback?

      • I see this deal as a quid pro quo for the banks getting recaps in exchange for writedowns. Because it is a negotiated agreement of a sort of payment in kind, it isn’t really clear if the banks are being made whole (as compared to a CDS-triggering default) as a result. Marc Chandler’s take was interesting. he was saying this was really debt foregiveness, meaning that the banks have done a debt jubilee for Greece in exchange for recapitalisation backstops. I like that angle.

        • David Lazarus says:

          Yes we are in agreement. It is a quid pro quo deal, so what do tax payers get from such a deal? While it might work for banks what about pension funds? I am sure that they cannot afford to reduce the pension pots 50%. How will they be made whole without a credit event triggering CDS payout?

  2. Dave Holden says:

    RT has been kicking the coverage of this crisis out of the park – sadly I rarely see this kind of analysis on UK MSM.

  3. fresno dan says:

    “Tis better to be silent and be thought a fool, than to speak and remove all doubt…”

    Despite that excellent advice, I will at least ask a series of stupid questions about CDS’s.

    A bond (at least when my collegues the dinosaurs ruled the earth and I took an economic’s class) had an interest rate. The theory or rationale for this rate is determined by the risk – higher risk, more yield.

    Now, with CDS I see a few things that just don’t make sense to me:
    A. The risk is the risk is the risk, and the expense is the expense is the expense (rate of default) – but the expense will be higher if you have the added expense of insurance. If you sell CDS’s (“insurance”) you gotta pay your insurance administrative costs, as well as make a profit. Now I know what your gonna say – hey, these sophisticated CDS sellers know how to ?price? ?predict? default BETTER than bond buyers….REALLY!? Like now????

    B. If you have insurance companies, they are regulated to make sure they have the wherewithal to pay claims. So….wasn’t a big problem with the financial crisis that AIG wrote “policies” that it couldn’t back up? Isn’t the fear that if losses aren’t imposed, a lot more people will be rooting for default? And that this CDS market is a total sham – it simply can’t come close to paying all valid claims? If that is true, how can the MARKET allow it to exist? If people who buy bonds can’t figure out the risk of bond buying, how is it they’re suppose to be able to figure out the risk of the CDS issuer being able to make good on defaulted bonds???

    Are these current Greek CDS’s actually CAPABLE of being paid off?…without causing the CDS issuers to default themselves? Does anybody REALLY know – they have like spreadsheets…that are like marked to market? Why do businesses that can’t do what they claim to do even allowed to exist BY THE MARKET???

    It seems to me that we have a bunch of people selling products that only work if they are never used. And we have a bunch of people buying said products who don’t seem to care….
    But I have just a dinosaur brain to use – you mammals are much cleaverer than me….

    • Always appropriate to ask. Here’s my take here. First, a good article at Dealbreaker breaks some things down:

      http://dealbreaker.com/2011/10/mandatory-greek-cds-post

      Take a look at that.

      Second, CDS in general were called weapons of financial mass destruction for a reason. We see it here. I am sympathetic to the concept of neutering them in this way but, as I indicated, doing so will have negative unintended consequences. Moreover, trying to call this a non-default and then having the private sector take a loss voluntarily but the Troika and ECB not really subverts the rule of law. I can understand trying to do this if no principal writedown was taken as in the July 21 deal. But now we are seeing a loss of principal. It’s a farce to say this is not a default. You have to respect existing financial contracts.

      The best way to get rid of CDS is to regulate them tightly. Make margin requirements right. We saw the same problem with AIG and those margin requirements. Clearly, the fact that bond yields will go up now that CDS has been undermined tells you implicitly that there is not enough margin. I say ban naked CDS, ban future sovereign CDS and slowly strangle the market until existing contracts expire.

      • David Lazarus says:

        Better still force all CDS contracts to be for set terms so that they can be traded on an exchange so that everyone can see who is exposed and top what extent. That exposure will mean that banks will find that the cost of writing such business is not worth the exposure.

        • 100%. That is the first step of regulating them adequately. Get rid of the OTC nature of the CDS market immediately without loopholes, as Geithner has suggested. That definitely makes it easier to understand exposures and is critical in getting a better handle on the financial services industry. Why don’t the banks want this? It is in their interest.

      • Dave Holden says:

        Some of the comments on that article are pretty funny.

      • fresno dan says:

        OK, I took a look. and it said:
        Of course that argument shouldn’t be taken too far, because it’s a backwards induction argument: someone will buy it because they think (someone will buy it because they think [recurse]) it has a payout schedule corresponding in a predictable way to a possible reality. If the thing doesn’t pay out when it’s supposed to, the backward induction doesn’t work. For someone to be willing to close out your CDS today, they have to think it’s worth something – that it would pay out in the circumstances where it’s supposed to pay out. And why would they think that?

        And than it said:
        Well, because it probably would. If you wanted to be a jerk, you could buy $1000 of Greek bonds and $1000 of CDS and wait.

        And:
        All that is obvious. But you have to be a jerk to do it.

        and than:
        But if you’re selling that basis package, someone must be buying it, and the guy buying it is a jerk

        And:
        But I think the freakout also reflects how counterintuitive it is that you need so few jerks to make CDS work.

        And finally:
        Greek CDS “works” only in the limit case, only for a non-bank investor who’s willing to be a jerk and run a certain amount of politico-PR risk. But that doesn’t mean it mostly doesn’t work. It means it entirely works.

        Hmmmmmm…I had to apply both my dinosaur head brain, as well as my dinosaur ass brain
        http://www.straightdope.com/columns/read/365/did-dinosaurs-have-a-separate-brain-in-their-behinds

        to (dare I say it???) – get to the bottom of this.

        The only thing I can understand is that CDS buyers are jerks. Maybe bond buyers too…

        Of course, being a dinosaur, I would question a mammalian system so dependent upon jerks to begin with…but than, thats just ass talk.

    • Mondo says:

      Exactly, and that is why not triggering the CDS’s is actually a great idea. Let’s hope that CDS buyers get the message and just stay away – no buyers, no market :-).

      The only way to defuse CDS’s without causing unpredictable havoc seems to be to have the problematic ones expire without them being triggered, pay out others as necessary, and not create any new ones.

      • David Lazarus says:

        Yes but if they can never pay out then there will be years of litigation to get refunds for monies paid.

  4. Dave Holden says:

    A good deal of what I’ve learnt has come from asking stupid question – I’m sure a resident expert will give you a good answer but my limited understanding is that no one has a clue whether the CDS issuers have the money. But I suspect a big clue is the efforts that have gone into making this “default” voluntary.

    • David Lazarus says:

      That is why Giethner has been making so many trips to Europe, to protect the US banks.

  5. Very much agree. Also: never buy bonds governed by the same legal jurisdiction as where the borrower is located: http://bit.ly/vmoMxv

  6. anon says:

    Since the haircuts are voluntary, only big banks will take them – who get recapitalization in exchange. Why would they sue?

    Small private investors owning Greek bonds can keep them – why would they sue?

    The ones who get shafted are speculative, naked CDS owners. But what standing do they have to sue? No bondholder got disadvantaged – no harm – no credit default event.

    Brilliant.

    • David Lazarus says:

      Small investors would be find that their bonds will not be worth the face value, even if they held to maturity. So they would be trapped, unable to sell them.

      The issue is not Naked Greek CDS, which are probably payable anyway. The sums involved are probably minimal. What is the problem is the value of CDS on the bigger problem nations, such as Ireland, Spain and Italy.

  7. anon says:

    Since the haircuts are voluntary, only big banks will take them – who get recapitalization in exchange. Why would they sue?

    Small private investors owning Greek bonds can keep them – why would they sue?

    The ones who lose are the speculative, naked CDS owners. But what standing do they have to sue? No bondholder got disadvantaged – no harm – no credit default event.

    Brilliant.