Streetwise Professor

October 26, 2011

Greek Tragedy

Filed under: Clearing,Derivatives,Economics,Financial Crisis II,Politics,Regulation — The Professor @ 12:10 pm

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.

Greek CDS represents about 1 percent of debt outstanding, with a notional amount outstanding of about $4 billion.

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.

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  1. The numbers for Greece are ridiculous. Assuming only 1.5 MM tax payers (best estimate I can find) for a country of 11 MM and debt of $471 MMM that amounts to a staggering $314,000 per tax payer.

    The 2 MM self employed for the most part just do not pay taxes-strictly off the books cash transactions.

    Comment by pahoben — October 26, 2011 @ 2:41 pm

  2. –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.–

    You’re right, of course. Then again, do you have any convincing reason, other than some other guy said it was so, for assuming that CDS payouts are the main issue here? If it’s too good to be true, it probably isn’t.

    Comment by CHB — October 26, 2011 @ 2:53 pm

  3. @CHB–I’m going by what the Eurocrats say. They seem petrified at the possibility that CDS would be triggered. That’s a $4 billion event, tops=$2.8 billion given even a 70 percent haircut.

    The ProfessorComment by The Professor — October 26, 2011 @ 4:19 pm

  4. I think that the Euros are grossly understating the exposure by quoting a net number. A lot of their clearing has been periodically netted using external services that do a breakage (cost) calculation, often reducing the gross exposures by 80+% (netting “near like” trades at a calculated ISDA formula that escapes me). But not all trades are netted.

    On the surface, what they are saying makes no sense re Euro 4MMM. This leaves us with several options:

    1. They don’t know what they are talking about.
    2. The net number is a lie. or includes trades at notional and not at strike – e.g the actual cash movement may be larger than the net number indicates.
    3. They are using CDS as a whipping boy to force an agreement and or give them political cover if things screw up.
    4. The un-netted trades may include counter parties that cannot pay or whose payments would cause embarrassment (e.g. someone has been lying). In the old days we would call this a round robin fail – happened in MBS all the time, especially when deliveries were physical (e.g. Goldman fails on a pool to Salomon, who then fails that pool to the House of Paine, etc). This could be systemic.
    5. General hysteria (Italy, anyone?) at someone having to pay – triggering even worse internal squabbles than are already present. Notice how the Finance Ministers’ meeting has been cancelled several times?
    6. The IFRS equivalent of FASB 115 and follow ups on Other than Credit and Credit Impairment might force all the institutions to book a permanent impairment. According to some friends who know a lot about this stuff, this includes a lot of Insurance Companies in France that so far have gone under the radar. They may not have liquidity in place to handle a sudden draw down. Also any fail to pay will put all the hedged positions in an accounting limbo.

    None, any and all of the above may apply.

    Comment by Sotos — October 26, 2011 @ 6:26 pm

  5. Forgot to mention – in the US the loss is determined not by recoveries but by a a bid in process among dealers – where they would buy in the paper. There was vast relief when the Feds took F&F as the notes and Debentures were effectively government guaranteed, so the bid ins were high and the payout was low. Does anyone know if this is how the Euro CDS work? If so, what if the bid in is at 10? Even if the Bid in is at current (higher) market levels, how can anyone hold the paper at a higher mark?

    Comment by Sotos — October 26, 2011 @ 7:10 pm

  6. Prof,

    It’s pretty obvious that the 4 bn net is a figure that does no justice to the actual havoc a default or universally imposed haircut, let alone a Greek bankruptcy, would create. Assume narrowly that a couple of large French and German institutions come out badly from the shuffle and you have issues of national (read ‘patriotic’) interest forcing a ‘voluntary’, non-triggering, markdown on participants. Then mix in the evident fact that the outcome for Greece also matters and the shortcomings of Bloomberg simplicity become evident.

    Comment by CHB — October 27, 2011 @ 1:04 am

  7. “The precise details will have to wait until November. But a deal to ramp up the bailout fund by around fourfold was enough to lift U.S. stocks and push U.S. Treasuries lower.”

    “But ultimately, Europe will have to divulge the specific details to convince markets that they are finally getting a handle on a debt crisis that flared up in late 2009” – or so they thing at Reuters.

    As far as I’m concerned, the next move by Michel Barnier is pretty obvious: a ban on divulging the specific details.

    Comment by Ivan — October 27, 2011 @ 4:14 am

  8. thing->think

    Comment by Ivan — October 27, 2011 @ 4:15 am

  9. Well they did it – fiction triumphs over reality – the current reading is that the 50% haircut on the Greek debt agreed by the banks was “voluntary”, so there is no default, thus no CDS trigger. Right now I am all for fiction – you cannot fight the tape. I take back previous comments about the lack of creativity in Europe – they are the bomb!

    Comment by Sotos — October 27, 2011 @ 10:40 am

  10. @Sotos. Yes. Fiction indeed. Fighting the tape=Tinker Bell rally. Eventually, the euphoria will subside.

    Some facts. First, will the banks actually accept the 50 percent haircut? Under pressure, their mouthpiece said yes: there is much room to doubt that the “volunteers” will actually show up when called. Second, the arithmetic still doesn’t work. Just last weekend the assessment was that Greece needed 60 percent forgiveness on its entire debt to get to sustainable levels. A 50 percent haircut that really doesn’t look like true forgiveness on about 60 percent of the debt gets you at best half-way to where Greece needed to go.

    The ProfessorComment by The Professor — October 27, 2011 @ 11:09 am

  11. @Sotos. And the bank recapitalization is a joke. Where is the money going to come from? This is purely aspirational, and doesn’t even really focus on the French and German banks. And leveraging the EFSF. Just where is the other 80 percent going to come from? Again, they announce an aspiration, not a plan on how to achieve the aspiration.

    The ProfessorComment by The Professor — October 27, 2011 @ 11:22 am

  12. Count me in your Amen corner – couldn’t say it better myself, which is why you are the blogger and true bomb. Cannot say how much I enjoy and appreciate your work.

    Comment by Sotos — October 27, 2011 @ 11:41 am

  13. It basically comes out to 28% of net Greek debt when you remove the Troika tranches and the bonds held by the ECB. Who holds the majority of the remainder? I’m assuming greek banks/pensions/etc, hence how they can guarantee the ‘willingness’ to accept.

    Comment by Jack — October 27, 2011 @ 12:28 pm

  14. @Sotos-Thanks so much. I really appreciate it. Hope to continue to meet your expectations. I really enjoy your comments . . . insightful, thoughtful: keep ’em coming!

    The ProfessorComment by The Professor — October 27, 2011 @ 4:40 pm

  15. @Jack–yes, 28 pct which is about 50 pct of the 60 pct writedown that would be needed to get Greek debt to within hailing distance of sustainability. And like you say, the 28 pct is the maximum, because as you note, there is no guarantee that those who have been volunteered will actually do what they has been promised in their name.

    The ProfessorComment by The Professor — October 27, 2011 @ 6:06 pm

  16. MF Global had quite a few of the smartest men in the financial industry managing their assets. They also had access to the ultimate insider info, because their CEO, Jon Corzine, was a Federal Reserve Bankster insider. So, how could so many of the nation’s brightest make such boneheaded decisions?

    Once again I want to emphasize that for every loser in the financial derivatives market, there is an equal and opposite winner, making tons of cash.

    Since 70% of the 1500 trillion dollar derivatives market is bets against interest rates going up or down, one would think that the former Chairman of Goldman Sachs would have some kind of clue on what the banksters were doing with interest rates. Some would argue that the loss of $40 billion dollars was a huge mistake. I would argue that there are no mistakes when it comes to the Satanic Psychopaths!

    Comment by Craig — November 7, 2011 @ 10:57 am

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