Like Tim Worstall, I am puzzled at all of the machinations in Europe to avoid a hard Greek default in order to avoid triggering CDS. Apparently the concern is that payoffs on CDS would potentially jeopardize the financial health of banks that sold protection, leading to contagion.
Look. If European banks collectively cannot handle a $4 billion payout (which would be the maximum, assuming zero recovery), then their problems are even worse than feared.
To worry about the $4 billion CDS, rather than the $471 billion in outstanding Greek government debt, is beyond bizarre. This suggests some weird sort of obsession among the Euros about derivatives, and CDS in particular. You don’t have to look far for more evidence of this obsession.
And remember, CDS are zero sum. Ever dollar paid by one party is received by the counterparty.
Moreover, many of the CDS contracts will have been entered by banks looking to hedge exposure to Greek sovereign debt, and private Greek debt. Restructuring Greek debt in a way that leads to substantial writedowns but does not trigger CDS screws the hedgers worst: they suffer losses on their bonds, and their hedges do them no good whatsoever.
Punish the hedgers. Wow. That’s a really constructive policy.
And there are long-term consequences. In particular, the effective abrogation of Greek sovereign CDS contracts will raise questions about the reliability of other outstanding sov CDS. Many hedges are looking far shakier now, for if the Euros do backflips to avoid triggering Greek CDS payouts, just think of what they would do for Italy or Spain. Since it is the most risk averse banks that would have decided to hedge, and since risk aversion depends in large part on the bank’s financial condition, this hurts the most risk averse (and likely weakest) banks most. Less hedging will be done going forward, but risks will be transferred regardless–through the cash markets. CDS prices will become less reliable (probably a feature rather than a bug to the Eurocrats).
Ironically, this creates a new speculative trade–a trade on the basis between CDS and the bonds–in which the parties effectively speculate on the political risk inherent in CDS.
There will be knock-on effects too. If private contracts can be circumvented for political reasons in the case of sovereign CDS, the risk that other derivative contracts can be effectively nullified increases too. The risk is probably greatest for other CDS–notably European bank CDS–but it exists for other types of derivatives too. All because once you admit the principle that “payouts on derivatives contracts can spread contagion”, you can’t limit its application–or the risk that the principle will be applied–only to Greek CDS. Just this once. Pinky swear.
Looking at the whole European fiasco brings to mind Churchill’s quote about the United States always doing the right thing, after trying everything else first. The Euros try about everything, but they don’t look like they are going to the right thing. The exact opposite in fact.