Friday, October 28, 2011

Help! I need a CDS for my CDS

To me, one of the strangest parts of the latest EU bailout-rescue fund saga is Brussels' seeming determination to kill off the sovereign CDS market. I wrote about it back in July, but in this current round, the issue is much more stark.

Private investors are supposed to take a "voluntary" 50% haircut on Greek sovereign debt. The reason why EU negotiators worked so hard to get it called voluntary is that they don't want the default to trigger payment clauses in CDS contracts.

Why they so strenuously object to this is not fully clear (at least to me). Maybe they feel like if the CDS don't pay out, it's not really a default? Maybe they think they are being clever and "punishing evil speculators"?

But it's not really that simple.

First, the ability to buy insurance puts more people into the Greek (and Italian and Spanish) sovereign debt markets than would otherwise be there. At the margin, invalidating these insurance policies will drive people out of the very markets the EU is begging people to enter.

Second, if I ran a bank that held Greek debt that was hedged via CDS, I would fight like hell against accepting the haircut. After all it's voluntary, right? I'd wait around until a haircut that would trigger my insurance payment came on the horizon. And, if I somehow got strong-armed into taking the "voluntary" 50% reduction, I'd litigate and fight like hell to force the insurance to be paid to me anyway.

However, I guess I wouldn't worry too much about the CDS not triggering yet though. This deal, as a best case scenario (i.e. everyone accepts the voluntary haircut and Greece hits all its promised revenue and deficit targets for the next decade) reduces the Greek Debt/GDP ratio from 180% to 120% in 10 years! Why doesn't a 50% haircut cut the debt ratio by at least 50% (more if you think the Greek economy will expand at all in the next 10 years)? Because at this point a lot of the debt is payable to the ECB, IMF and other "official" creditors who are not taking a seat in the barber's chair.

1 comment:

Hasdrubal said...

I can understand CDSs for bond holders, that's basically just an insurance policy for risk averse investors like banks, insurance companies and pension funds.

But CDSs for bonds you don't hold? I can't get my head around selling those. It's a revenue stream, but gives you tremendous downside risk, and if the bonds you're insuring are correlated, wouldn't a payment event be almost certain to break the bank? I'm not seeing a way for these to increase liquidity or the availability of credit in the market. As far as I can tell, they're just wealth transfers.

So, I can understand the antipathy towards CDSs if a significant proportion of them are issued to institutions that don't own the bonds. I don't have any problem with wealth transfers in general, but these seem specifically designed to transfer wealth either from investors to insurance companies, or from taxpayers to investors if the CDS actually has to pay out. I prefer to gamble my own money, not let others use my money to cover their bets.