Thursday, February 23, 2012

The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

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