Perhaps someone could explain this to me?

If the banks called the EU-ECB-IMF troika’s bluff, they would potentially face nationalisation. A “credit event” would risk triggering credit default swaps – the scale of losses from which cannot be accurately quantified.

I would have thought that we would know the scale of losses from a credit event.

Say the Greek default leads to a 50% haircut on their €350 billion of debt.

The losses will therefore be €175 billion.

A credit event would mean that all of those various credit default swaps are triggered. And the nominal value of all of those CDS contacts is some huge number. But won\’t they all collapse down to €175 billion?

That is, we know the scale of losses from a default, we just don\’t know where those losses are going to turn up? Because we don\’t quite know how the interlocking CDS contracts will all work out, who will end up holding the baby?

What have I missed here?

Oh, and haven\’t the losses already been paid up anyway? As a CDS position moves into loss (or on the other side, profit) there are daily collateral payments, aren\’t there? So the money that would be moved around by a credit event has already been moved around? What a credit event would do is simply crystallise those movements that have already happaned, turn them from collateral into profit (loss)?

I must have missed something here because everyone seems terribly worried about a credit event but I just can\’t quite see it. There is no AIGFP out there that has been writing CDS without having to post collateral.

Would one of the City readers please correct me?

14 thoughts on “Perhaps someone could explain this to me?”

  1. I my be wrong, but I understood that it was possible to insure against a default without actually having any stake in the debt. That is, it is possible for the total value of the CDSs to exceed the total debt.

  2. A hard default means defaulting first, negotiating the haircut second. So yes CDS would be triggered, but noone would know the amount until the negotiations are finalised.
    (That’s just my understanding, perhaps wrong. I don’t work in the City.)

  3. It’s scaremongering, according to this guy
    He says DTCC evidence is that CDS net exposure is less than 1% of bonds outstanding. I’ve heard that from other people too.

    Also, do people really think the big banks have done NOTHING to reduce their exposure? Of course they have. I’d be surprised if any of the major banks now have significant CDS exposure to Greece or the other PIIGS. If you want to know where the risk is, look at hedge funds. But they’re a canny lot. They’ll probably make a mint out of it all.

  4. I don’t think there have been margin payments, and there’s uncertainty over gross exposure – some say 78 billion, some say a lot more.

  5. CDS is marked to market, so people holding contracts will have already taken losses/profits.

    In a credit event the recovery rate might not necessarily equal where CDS was trading, so there might be another loss there, but it tends not to be wildly off (in fact, recovery rates tend to exceed the losses priced in historically).

    Banks have large CDS exposure, but their real problem is the amount of Greek debt they were holding. Banks act a primary dealers for Greek bonds, so are obliged as terms of this service to show prices in any Greek bond a customer wants them to. This enabled a lot of pension funds to quickly offload their Greek risk onto the banks. Add that in to the stuff the banks were already holding as Tier 1 capital and they suddenly have a lot….

    ….which they pushed on to what are effectively non mark-to-market books where the bonds are due to be held to maturity, which meant they didn’t write the value of the bonds down.

  6. Out of my depth here but is it not the case that even tho’ UK banks may not have much exposure to Greek debt, they do have lots of exposure to banks/institutions who have exposure to PIIG debt?

    As Friedman pointed out it was the collapse of an obscure bank in Austria that triggered off the 1929 Crash. In a world with vastly more debt, esp govt debt, than ability to pay it, it seems unlikely that all the present turmoil is going to end as a damp squib, regardless of how many want it to.

  7. Isn’t the problem that the institutions paying out might not be able to, so it doesn’t all net out. And if institutions are payers as well as recipients, if they don’t get their receipts (because their payers are bust), then they can’t make their payments either, so it ripples out.

    If there already have been proper collateral or margin payments, and they are big enough, then not a problem. But I don’t know enough to know whether they are.

  8. I think the point is that the banks hold a lot more assets backed by these bonds + CDSs. Marking to market one asset, means all the much larger amount of other derivatives that use that as collateral, must be priced down too.
    The problem is that the acceptance of derivatives backed by derivatives, etc, has enabled banks to become much more leveraged, and the further away from physical assets one gets, the more the intangible the asset becomes, with its value largely dependent on accounting practice.

  9. 1) Posting collateral is not the same as paying variation margin. The money is still yours.

    2) Even if default is likely, buying CDS is still insurance against a possible event, not a certainty. So the writer will still lose money if there is a default (unless the recovery rate is unexpectedly high).

    3) Reportedly the Greek write-down is going to be by means of a notionally voluntary exchange of bonds (but with the banks having been persuaded in advance to accept it). If that’s the case, Greek sovereign CDS will not be triggered by it.

  10. Derivatives markets generally operate mark to market on collateral.

    Bank’s financial accounts on sovereign debt assume full repayment except where there has been a voluntary write-down. The 20% so far has been voluntary (arm-twisted). Default requires write-down in the accounts, which drive formal capital for regulatory purposes. So formal default creates a regulatory event and either closure or capital raising.

    CDS are insurance contracts, not the usual derivatives, and do not necessarily require collateralisation. That depends on the contract.

    Finally, formal default as defined by the body governing the conduct of CDS would require cash payments to be made. Let us assume European banks have issued CDS on Greece net to hedge funds. Formal default would transfer net money out of banks into hedge funds, even if the net total of payments were only based on the Greek government debt issuance.

  11. So ISDA (the governing body for CDS) decided that a 50% voluntary write-down did not constitute a default. Big benefit to banks, who don’t have to take the revenue they’ve already written for selling CDS to hedge funds, nor provide the cash. Eurozone bank shares are up as much as 20% on the announced package, half of which came after the ISDA announcement.

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