The epistemics of Greek default

By Felix Salmon
February 22, 2012
headline in the NYT saying, disturbingly, that the "Greek Crisis Raises New Fears Over Credit-Default Swaps"? Don't be.

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Are you alarmed by today’s headline in the NYT saying, disturbingly, that the “Greek Crisis Raises New Fears Over Credit-Default Swaps”? Don’t be. The article in question turns out to be a solid 770-word explainer by Peter Eavis in which he gives the final word to Stanford’s Darrell Duffie, saying that any such fears are “small potatoes”.

But at the beginning, Eavis talks about how European policymakers “fear that payments on the swaps might set off destabilizing chain reactions through Europe’s financial system”; later on, he writes that “the swaps will also come under heavy fire if there is any indication that activating the Greek instruments is leading to stress in the financial system”. It would have been nice if he’d named one of those policymakers, or explained what exactly their fears might be.

How, exactly, would a CDS trigger lead to stress in the financial system? After all, as Eavis concedes, every time banks’ balance sheets have been examined, regulators have found essentially nothing in the way of unhedged CDS exposures.

There is the possibility of counterparty risk — a spectre Eavis raises only to dismiss it. In order for counterparty risk to be a problem, you need two things. First, you need a bank with a very large unhedged CDS exposure to one single name — the kind of position I’ve never seen any bank have. (Remember here that credit default swaps were invented for banks to sell down their loan exposure, not to increase it.) And then, on top of that, you need jump risk: the risk that the single name in question will suddenly default, forcing the bank to pay out a huge amount of money at once.

But in Greece, there is no jump risk at all. Because a default has been priced in for months, any bank which has written default protection on Greece has had to steadily post more and more margin against that position. When Greece officially defaults at the end of March, there will be an auction to determine the clearing price of the swaps, and the margin will simply get transferred to the bank’s counterparty. The bank will probably need to make no payment at all.

In other words, counterparty risk on sovereign CDS is probably a non-issue, but it’s certainly a non-issue in Greece.

So what are the “new fears” of Eavis’s headline? I’m beginning to think that in fact the fears are not that the swaps will get triggered, causing some kind of financial calamity, but rather that they won’t be:

Some chance remains that the exchange could be done voluntarily, avoiding a default swap event. That outcome would most likely prompt a torrent of criticism that the swaps did not cover holders against losses, as they were intended to.

“The whole nature of the C.D.S. contract would be called into question,” said Richard Portes, professor of economics at the London Business School.

As Eavis says, the chance of the swaps not being triggered is extremely small, at this point. But it’s higher than the chance that the trigger will cause some kind of financial-market calamity. It’s possible — unlikely, but possible — that Greece will get such a large acceptance rate on its exchange offer that the size of the holdouts would be very small indeed. If that happens, it’s also possible-but-unlikely that Greece will choose to simply continue paying those holdouts in full, rather than defaulting on them or trying to bail them into the deal through CACs. If both of those possible-but-unlikely things happen, then it’s definitely possible ISDA would determine that there was no credit event. But we’re so far down the chain of speculation at this point that these things are really not worth worrying about; the unanimous consensus in the market is that there will be a default, in March, and that the CDS will get triggered.

The thing that really worries me is not the CDS market at all. In fact, for all that credit default swaps were an intrinsic part of the financial crisis, the traded market in CDS has been remarkably robust. It certainly withstood the bankruptcy of Lehman without any trouble, both in terms of counterparty risk relating to Lehman’s own positions and in terms of CDS on Lehman being triggered when the bank failed.

Rather, what worries me is that the vast majority of people reading this article in the NYT will see the headline about New Fears, and if they skim the article will just see a bunch of concerns and some quotes from people on both sides. In other words, Eavis’s article is to a large degree self-fulfilling: people will read it and start being worried about the CDS market all over again, especially if — like 99% of the population — they don’t really understand the CDS market at all, and have no particular need or desire to get into the nitty-gritty. All they know, or think they know, is that credit default swaps are Dangerous Complex Derivatives, and that the Greek crisis is making them more dangerous still.

Meanwhile, Eavis never touches on what I’m pretty sure is the real reason that European policymakers are worried about a CDS trigger. A lot of people have been asking me about the Greek deal in recent days and weeks, and I get a lot of questions like the one I was asked yesterday by Amanda Lang, who asked whether default was in fact inevitable and whether Greece was just putting it off with this deal, kicking the can down the road. A lot of otherwise very well-informed people still think that this bailout is like previous bailouts, designed to avert a default. When in fact a huge default is right at its very heart. When the CDS get triggered, it’s going to be very obvious that this is indeed a Greek default. That’s something which bond market professionals are acutely aware of, but it hasn’t really sunk in to the broader popular consciousness.

If the Greeks and the Europeans can structure a deal where the credit default swaps aren’t triggered and the bondholders voluntarily swap their old bonds for new bonds, then it’s actually possible that this misunderstanding could continue well past the bond exchange, to the point that the broad public thinks that we’ve just seen another bailout, and misses the footnote that the bailout was accompanied by the single largest bond default in the history of the world.

If all goes according to plan, this is going to be an orderly bond default, to be sure — in contrast to the very disorderly defaults we’ve seen in recent years in countries like Argentina and Ecuador. But make no mistake: Ecuador Greece owes €14 billion to its bondholders on March 20. It is not going to make that payment, and instead bondholders who are currently owed 100 cents on March 20 will find themselves instead with a mixture of securities worth maybe 26 cents on the open market. When the CDS get triggered, that fact is going to get hammered home. Because although it has long been priced in to the market, it still isn’t broadly understood.

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