Misundertanding the Greek debts and CDS

Britain\’s banks hold about £2.5bn of Greek bonds.

OK, so now we know that number.

Senior European figures said London needed to focus more urgently on the potential effect of a Greek default on the UK\’s banking sector and economy.

\”The UK has the third largest exposure after France and Germany,\” said a high-level EU source. \”It should be aware of the effect of standing aside from discussions.\”

Nada. Zilch. SFA.

The City paid out £8 billion in bonuses last year, recall? This is less than one third of that. Given that the haircut is likely to be around 50%, the actual amount at risk is one sixth of that.

This isn\’t quite just a burp after a good lunch, possibly more like a slightly worrying fart the night after a good curry, but just not a major concern over the stability of the system.

Simply trivial.

Another worry is that Britain\’s banks and hedge funds have written multibillion-pound insurance contracts – credit default swaps – that would be triggered if Greece defaults.

Erik Britton, director of City consultancy Fathom, said: \”It\’s not the direct exposure, it\’s the indirect exposure and the implications of an unruly default that I would be worried about. French and German banks bought Greek bonds, and they took out insurance against default. Who did they take out that insurance with? The US and UK banks. There has to be a loser – who\’s the loser?\”

There\’s two problems here.

The first is that all this effort going into making private sector involvement in the haircut voluntary is an attempt to make sure that it is not declared a credit event and is thus not a trigger for those CDS payout.

The second is more important. Everyone who is going to lose money on a CDS has already lost money on that CDS. This simply will not work out like AIG Financial Products.

Recall what the problem there was. AIG had an AAA credit rating. This meant that it did not have to put up collateral when prices moved against it. So they could write a CDS, offering insurance, collect the premium, and then they only had to pay out if there actually was a credit event which triggered that payout.

What they did not have to do was, as they saw prices moving against them, stump up the daily margin of how much those prices had moved against them. So as prices did move against them they had huge potential liablilities building up but no actual cash flow moving out the door to remind them of all this. Then they lost their AAA rating and they had to come up with that 100 billionish in cash to cover those margin payments they hadn\’t previously had to make.

That\’s what bust them. Yes, they may well have been insolvent as well but they were certainly illiquid.

What\’s the situation now? Well, there\’s no one left with an AAA rating writing CDS, so there\’s no one in that situation. Further, the rules of the contracts have been changed, everyone, but everyone, puts up those daily margins as prices move (either way).

So, are there losses on the £30 billion of Greek Govt CDS contracts? Sure there are (but do note that there are thought to be only that £30 billion of them, gross, many of them will nett off against each other). Will a default or a credit event lead to losses being crystalised? Sure. But will it lead to a run on cash, to people unable to cough up because they\’re illiquid?

No, it won\’t, for everyone making a loss has already handed over the cash as that daily margin.

We know who will lose for we can go and count who has already handed over those margin calls. In fact, we know who will lose because we can work out who has already lost. Just look at the cash balances.

What worries me far more than anything else about this story is that someone running a City consultancy doesn\’t know this basic thing about the City he is consulting about.

That\’s shit scary.

10 comments on “Misundertanding the Greek debts and CDS

  1. Isn’t it a truism that “someone running a xxxx consultancy doesn’t know this basic thing about the xxxx he is consulting about.” ?

  2. I know nothing about CDS contracts (so rather like the Guardian writer). But in general, aren’t margin calls usually a percentage of the potential payout, not the full amount? Perhaps it’s different in a CDS, but ‘margin call’ didn’t make me think the whole amount was covered.

  3. “What worries me far more than anything else about this story is that someone running a City consultancy doesn’t know this basic thing about the City he is consulting about.”

    Well, that’s par for the course.

    Of course these CDS are nothing to worry about, in extremis the UK government could declare that liabilities under a CDS have the same status as gambling or prostitution debts, i.e. not enforceable in a court of law, problem solved.

    What this is really about is the banks ‘sending a message’ to the UK government that they are too big too fail and could do with bailing out again or else Something Terrible Will Happen But We Know Not What.

  4. It occurs to me that HMG effectively owns RBS and LloydsTSB. So it could instruct them to go through their books, identify all the debts they owe each other, and nullify balancing amounts of them. Similarly, they could identify equal-and-opposite financial bets and nullify them too (with balancing compensation paid to play fair by the other shareholders). What disadvantage have I overlooked?

    Tim adds: Re the equal and opposite financial bets: but that’s exactly what does happen in derivatives markets. It’s what “nett exposure” means.

    When Lehman went down with $600 billion or whatever it was of derivatives outstanding net claims, after netting off, were $6 billion or so in the resolution process.

    CDS contracts work exactly the same way. So, let’s say Greek bonds are trading at par, at 100%. I buy a CDS. Then theior price falls to 90%. Roughly speakling (but not exactly) we would therefore expect to hte CDS to be trading at 10 instead of the 0.5 or whatever I bought it at (0.2 maybe even).

    I want my profit and I want it now. But I can’t sell my CDS. Not possible. So I open another new one the opposite way around at the new price of 90%. The two contracts together nett off to lock in my profit.

    *That’s* why there’s such high CDS exposure. Because huge whacking great chunks of it nett off against each other.

  5. Fathom have been grossly overstating potential UK exposure for a while now. Either they don’t understand CDS and bond markets – in which case how can anyone take them seriously as a financial consultancy – or they have a vested interest in talking it up. Maybe they are betting on Greek default?

  6. “Re the equal and opposite financial bets: but that’s exactly what does happen in derivatives markets. It’s what “nett exposure” means”: fair enough. But if your bets have different counterparties, things could presumably get pretty nasty in a big crash when you may owe Snooks money while Bloggs, who owes you, is bust?

  7. You can’t just net off (at least in ordinary circumstances you can’t – the laws for banks may be different).

    Say X owes Y £5bn and Y owes X £5bn. Both sums are now due. But before either is paid, X goes bust.

    X’s liquidators demand the full £5bn from Y. Y has to pay up, but it doesn’t get the £5bn from X because X is in liquidation.

    Eventually Y will get some percentage of £5bn from the liquidators of X, but that doesn’t help them with their immediate cashflow problem of having to stump up the £5bn.

    If we allowed netting off, that would disadvantage the other creditors of X. Effectively Y would be getting their debt repaid in full (by the netting off), but the other creditors would only be getting a percentage.

    The lawyers try to come up with ways to ensure that you can net off even in the case of default, but it doesn’t always work.

  8. And it’s even worse if there are 3 parties involved (I think this is what dearime is getting at).

    Say X owes £5bn to Y, Y owes £5bn to Z, and Z owes £5bn to X.

    Overall it all nets off. But if X goes bust, Y doesn’t get its money but still has to pay Z. Meanwhile Z pays X, but that money gets tangled up in the liquidation and no-one sees any of it for a while.

    Sometimes there are attempts to get round this by using counterparties, so that all transactions are with N. So instead of X owing money to Y, X owes to N and N owes to X. N doesn’t do anything else except act as counterparty, so hopefully won’t go bust. But even then, if enough members of N fail to pay, N can go bust.

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