Europe's Default Crisis: It's the CDS, Stupid
"The constraints imposed by market forces [on government deficits inside a single-currency union] might either be too slow and weak, or too sudden and disruptive."
~ The Delors Committee report on European monetary union, getting it exactly right in 1989
Greek bonds have lost half to three-quarters of their face value. Six national strikes have all ended in violence already this year. In the three months to April, public investment spending fell 42% from the start of 2010, but total spending still rose - and tax revenues sank - forcing the budget deficit still wider as the economy shrank 5.5% year-on-year.
What to do? Greece's debt cannot be serviced, much less repaid. Everything says default - stop paying, write it down or write it off, with or without the lenders' consent. Default is certain, and history (that old balls-ache) says it would be better for creditors if the "restructuring" came before Greece misses a payment.
Uruguay's "pre-emptive" restructuring of 2003, for instance, cost its creditors 8% of their money, according to an IMF study. Argentina's "post-default" restructuring of 2005, in contrast, cost the affected bondholders some 75% of their original investment.
Yet incredibly, most everyone outside Greece - everyone who thinks they have a vested interest, at least - wants restructuring delayed and delayed again. Why? Because of the banks, stupid.
Only just rescued by taxpayers in 2007-2010, no one knows how badly the banking system will fare when a Greek (or Irish, Portuguese, Spanish or Italian) default strikes. Not through capital loss on the bonds; that's likely to be a drop in the bucket. Nor is the loss of Greek bonds as collateral - securities against which banks can borrow - the big issue either. In that market, "Greek state bonds have already been marked down by close to half their face value," says John Dizard at the FT, and besides, the European Central Bank is holding most of those. (So you can imagine the ECB's position on writing them off to zero.) In the private market, the "haircut" on credit extended against Irish and Portuguese bonds by LCH.Clearnet, a leading clearing house, has already gone to "75% and 65% respectively" says Tamara Burnell, head of sovereign research at London's M&G Credit Analysis team.
No, instead, it's the money owed to holders of credit default swaps - derivative contracts insuring against failed debt repayment - that risk taking the world straight back to September 2008. One estimate puts the insurance cover at 25% of Greece's outstanding debt. Another private estimate reaching us here at BullionVault puts the gross CDS insurance cover at twice Greece's €340 billion of outstanding debt.
Either way, the sheer scale of those claims would explain why the European Parliament is racing to make "profiteering" from a sovereign Euro default illegal. (So-called "naked CDS", where the claimant doesn't hold the bonds, but is betting that a default is coming, have become a big issue for Euro politicians, as we'll see.) It also explains why "The United States was concerned about a default on debt by Irish banks," as Dublin's former finance minister Brian Lenihan revealed in April.
"He said the US was concerned about credit default swap contracts being triggered," reported The Irish Times, "although he did not say why."
Anyway, back in the Greek crisis, "European banks are long about 17% of the €340 billion of total Greek sovereign debt outstanding," reckons Niels Jensen at Absolute Return Partners. "A 65% haircut [ie, write-off] would result in losses of €37-38 billion - not enough to create anything remotely looking like systemic risk." Shared across Western Europe's banking sector, in fact, the bond loss itself would be nothing compared to the IMF's estimate of $1.4 trillion lost in the region during the financial crisis of 2007-2010.
Even in credit default swaps - those contracts which "allow a buyer of credit protection to pay [an interest-rate] spread to the credit protection seller, in return for a settlement in case the [original debtor] incurs a credit event," as a handy cut-out-and-keep guide from 2005 put it - a Greek default would see "the overall net pay-out [of] only $5 billion," reports the Financial Times. Because Bank A's pay-out would enable Bank B to meet its Greek insurance promise to Bank C, who in turn could then settle with Bank A.
That net end-result would take some reaching, however, and the $5bn estimate - merely reflecting US bank exposure, it seems - "may not truly reflect the size of potential losses for some banks," the FT goes on. "The gross CDS exposure on Greece is $79bn and some analysts speculate that any one bank may have to pay out as much as $25bn."
Note that word "may". Because "there is no way of finding out about these [CDS] exposures," as analysts at BNP Paribas reminded everyone in Jan. 2010. Credit-default swaps were long traded 'over the counter', buyer-to-seller direct, with no central exchange or clearing-house recording every transaction for posterity. The US authorities have been racing to get CDS at least cleared through a recognized "central clearing party", somewhere they can monitor the liabilities, if not prevent the clearer going down amid a disorderly run of claims. But in the Bank for International Settlements' data - source of all the big figures above - some 6% of the global total for OTC derivatives comes from "estimated positions" based on a survey from four years ago. More telling still, that 6% outweighs the reported total of CDS, but "excludes [unreported] CDS for all countries except for the US."
Now, on those same data from the Bank for International Settlements, gross Greek CDS cover equals 3% of the total government-debt insurance market worldwide - a signficant chunk compared with Athens' share of total government debt in issue, now sitting at 0.9% by our maths today. So either Greece looks disproportionately shakey to bondholders (you don't say), or it's been over-insured by its bondholders, or it's been insured by people who don't yet own any Greek bonds, but who want to cash in when it defaults. Or all three at once.
When US automaker Delphi filed for Chapter 11 bankruptcy in 2005, for instance, "the volume of CDS outstanding was estimated at $28 billion against $5.2 billion of bonds and loans," according to derivatives expert Satyajit Das. And just as your insurance company might take possession of your wrecked car when it pays out - or it might demand receipts as proof of purchase on a household claim - so a big slug of those CDS on Delphi "require[d] the insured party to turn the underlying bonds over to the insurer when the payment [was] received," explained J.P.Morgan's Eric Rosen at a Wharton conference.
But not all CDS demanded delivery of the underlying bond, says Das. Which brings us to politics.
"Credit-default swaps, where you insure your neighbor's house just to destroy it and make money from it, that's exactly what we have to curb," said German chancellor Angela Merkel back in March 2010. "We must prevent speculative actions from causing so much uncertainty on the market that prices no longer provide accurate information and state financing reaches a fundamentally unjustifiable high level," she wrote - together with the political leaders of France, Greece and Luxembourg, also in March 2010 - urging an EU enquiry into "a well-founded suspicion that speculative practices are having a considerable impact on the development of [government bond] yields."
At the time, most financial journalists and commentators outside the Eurozone found this laughable. But in Spain, daily paper El Pais (amongst others) claimed that hedge funds and the Anglo-Saxon media were working together to push up CDS prices, thus driving down bonds (who'd buy a bond costing a fortune to insure?) and forcing Eurozone governments to pay ever-higher financing costs. Yes, seriously. It even said the Spanish secret police were investigating, and pointed to the Financial Times and Economist as sources of reckless comment.
Amid this frenzy, Merkel and Sarkozy asked the EU Commission to "also consider introducing minimum holding periods for CDS trading, banning speculative CDS trading, as well as banning the acquisition of CDS which are not being used for hedging purposes." A wish which has now very nearly been granted - but only at the snail's pace of Euro politics.
"Of course the ban on naked CDS will not solve the fiscal problems of Greece or Ireland. Nevertheless, when you face such a situation, you can choose to add fuel to the fire or put water on it. These instruments should not be used as a speculative tool anymore."
So said French Green Party MEP Pascal Canfin in February, after filing a report on CDS in January. Putting his proposals before the EU Parliament took until last week, however, and even then "the plenary vote was only used to collect significant majorities which should strengthen the hand of MEP negotiators in their ongoing talks with Member States," as Strasbourg's press release says. The discussion "decided the Parliament's stance"; it did not ban naked CDS, and the enforcement date entered isn't until 1 July 2012. For now, "OTC derivatives trading is not subject to any legislation other than that between the contracting parties," as German MEP Werner Langen put it. Which brings us to September 2008.
You'll recall how that panned out. Insurance-style payments owed by AIG, Lehmans and many others couldn't be covered as the financial markets blew up. Short of canceling private contracts made under the law, Washington opted to step in and the salvage the insurer, but not the investment bank, making good its payments with taxpayer cash. The same decision to honor private financial contracts - protection of banking deposits chief amongst them - was made across Europe, flipping the region's already over-stretched public finances into their sharpest peace-time deficits in modern history. Now that same taxpayer cash, still propping up the banks' balancesheets, is itself at risk, this time from a run of legally-recognized contracts, demanding payment when sovereign nations - those entities which decided and paid the bail-out to banks - fail to pay their own debts, swollen by those very same banking bail-outs.
The EU Parliament is developing a sweet tooth for such bitter ironies. This summer will see its new European Supervisory Authority on Securities and Markets (ESMA) start supervising credit rating agencies "directly", whatever that means. Because as German Liberal MEP Wolf Klinz explained Strasbourg's political anger this spring, "Credit rating agencies both rated [subprime] assets and at the same time were rendering advice services to the clients who were paying for the rating...
"An agency can [even] advise an investment bank how to structure a product to get the highest rating," the EU Parliament's news-service goes on, "although the product itself is thereby not made safer, it only looks like it is. Such irresponsible but highly profitable behaviour made the [banking] crisis worse, so governments (ie, taxpayers) had to go even deeper into debt to rescue their financial systems. However, worried by this increase in debt, the agencies are now downgrading countries and their bonds (the lower the rating, the higher interest rate and the higher debt burden), forcing the taxpayer to pay even more; governments respond with slashing spending on e.g. social services to placate 'the markets'."
Supervising credit agencies "directly" seems unlikely to encourage higher ratings on Eurozone sovereigns. Banning naked CDS will not make Greece solvent, give jobs to Spain's under-25s, or fill Ireland's ghost-town housing developments. Trying to avoid the financial and legal chaos of a "credit event" however - let alone paying profits to "predator" hedge funds (copyright Nicholas Sarkozy, 2007) out of the very same taxpayer bail-outs used to rescue the banks - looks set to prolong the pain in Athens.
Or maybe Greece won't wait.