Tuesday, July 26, 2011

European Credit Default Swaps: EU 15, Speculators Love?

An undercurrent of the EU sovereign debt crisis is that the Euro zone nations detest the speculators they believe have been gambling on the outcome of the Greek and other bailout efforts. Hedge funds and perhaps some investment banks dabble in credit default swaps protecting against defaults by various Euro zone nations as a way to gain speculative profits. While CDS's may have originated as hedging instruments, just about any financial instrument can be used to speculate as well as hedge. And CDS's, like many derivatives, can be traded on a leveraged basis, which makes them all the more appealing as speculative investments.

Euro zone governments loath speculators in CDS's of EU member nations' debt. Although CDS's nominally take their value from the market for the underlying financial instrument, there is a belief that derivatives markets can affect the markets for underlying financial instruments. In other words, a lot of CDS speculation on a Greek default might push the value of Greek bonds lower, increasing the potential for default by raising the market interest rates Greece must pay. The toxic interaction in the 1987 U.S. stock market crash between stocks and a type of derivatives contract called portfolio insurance fuels such beliefs. Portfolio insurance purported to guarantee the value of portfolios. Mutual funds, pension funds and other institutional investors flocked to this product (which is now extinct). When stocks dipped on Black Monday (Oct. 19, 1987), portfolio insurers began short selling underlying stocks in order hedge themselves against further stock drops. That short selling only increased the downward pressure on stocks, which triggered more selling and short selling. This increased selling impelled more short selling by portfolio insurers, which served only to fuel more panic. The market dropped a total of 22% that day, the greatest percentage drop ever, not excluding the 1929 stock market crash.

The EU's second bailout for Greece involves an expectation of a "voluntary" bond exchange by private holders of Greek debt for longer term debt, something that underlies the credit agencies' view of this bailout as a default. This exchange will entail a 20% loss for those holders. The exchange feature would lower the market value of Greek bonds and, perhaps, might be the sort of thing against which a CDS holder would expect protection. But the International Swaps and Derivatives Association, a trade organization composed of derivatives dealers, has decided that CDS obligations will not be triggered by the second Greek bailout because it doesn't change the terms for all holders of Greek debt. In other words, if a hedge fund holds a CDS on Greek debt and was hoping for a payout because the EU's bailout, part deux, would be considered a default by the rating agencies, it's out of luck.

How many speculators have been hurt by this decision, and how large their losses are, is unknown. The amount is probably not trivial, because all the volatility surrounding the Greek debt situation would provide a plenitude of speculative opportunities. Don't expect a lot of publicity about these losses. The speculators, knowing the EU member nations are probably quietly gloating over this victory, have plenty of reason to lick their wounds in silence. And don't be surprised if the EU, in the next bailout of Greece, Ireland, Portugal or whomever, doesn't try to structure things so that CDS's payment requirements again aren't triggered, and the speculators get spanked again.

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