Monday, 25 July 2011



Readers will have noted that I have refused to write anything on Thursday's Summit outcomes and the new Greek bailout. The fact of the matter is that the amount of information in the public domain is pitifully inadequate - and that's not just me saying this. I will try to update this post as new information comes out.

Greek readers can, for now, consider the very competent if politically charged discussion by Techie Chan on this matter. The gist of it, with which I completely agree, is that private creditors have taken far smaller losses than the 21% trumpeted by European leaders, and in fact will in some cases make a reasonable profit from this deal, that Greek debt is still unsustainably high, and that a large transfer of risk has taken place from Europe's banks to the European taxpayer. Stay tuned for my own discussion of this.

I am particularly disturbed by the triumphalism with which some news outlets aligned to the Greek government were reporting on the deal late last week, essentially calling doubters and naysayers out on their sour-faced skeptical remarks. They'd be shouting 'IN YOUR FAAAACE! IIIIN YOUR FACE!' if they could get away with it. Cue of course, a chorus of world-weary defaultniks lamenting the continued loss of sovereignty, decrying Shock Doctrine tactics (Naomi Klein's tedious political version of the Philosopher's Stone, which explains everything under the sun), denouncing the new interest rate as usurious and the like. Let them all talk.

I'd rather focus for now on a topic that fewer commentators are talking about back in Greece and for which the facts are actually out. This is the CDS market - remember the evil specuLOLtors that were supposedly betting on Greece going bust (some of whom were in fact Greek banks themselves)? Well they're pretty fxed now.

You see, the most important implication of Thursday's grand bargain was no outcome of the Summit talks themselves, but the earlier announcement by ISDA that such a deal would not constitute a credit event triggering CDS payouts. By confirming that politicians will use this loophole to its fullest extent, Thursday's announcements mean that CDS are now virtually a non-asset-class: they only ever pay out if Greece sticks two fingers up to our creditors a la #Debtocracy, or if some suit at the IMF forgets to put our welfare check in the mail. Neither of which will ever happen. Some back home may be cheering that CDS spreads are down but that's because the actual value of the CDS as a hedge is down, not because Greek debt is any safer. It's like police procurement chiefs cheering the savings created by the falling price of bulletproof vests, following test results that prove they can't stop bullets.

You may think this is something for teh EVIL specuLOLtors to sort out among themselves, but what it actually means is that Greek bonds are now going to become much more illiquid (and that's saying something considering how illiquid they are now), because investors can't hedge against losses. The same goes for Greek bank stocks: in the past, people might use a Greek bank + CDS combo to replicate a European bank portfolio and skim some of the arbitrage out of the market or use Greek CDS to hedge exposures in the Balkans and Eastern Europe. But worse, far worse, the same goes for other PIIG and European bonds, and their banks. The entire Eurozone's financial system has become less liquid overnight. Surely that can't be a good thing?

UPDATE: only a few hours after I wrote the few lines above, this happened. QED.



  1. Γιώργος25 July 2011 at 15:07

    CDS's are still a valid hedge if you own Greek bonds and plan to hold them to maturity. Otherwise you are correct. I guess that is the upshot of the comments in the linked alphaville post as well.

  2. I've been following your posts on and off over the past month or so, and you produce some very good material.

    I agree that CDS are looking more and more ineffectual, not only in light of the recent decision by the ISDA, but also just from the increased use of puts by hedge funds on Italian bonds as opposed to using the insurance market as a way to bet on higher yields.

    Question: why would the decreased use of CDS contracts make the underlying security less liquid? CDS were created as a way to mitigate portfolio risk without forcing the holder to sell the security to a third party. If you can't hedge against potential losses on your portfolio by buying insurance, this means that you have to offload risk directly by dumping the risky securities onto the market when the fair value is threatening to capsize your boat. This would a) cause a spike in liquidity and b) force these banks to mark these assets to market.

    CDS have proven valuable instruments at times, but they also have the capability of causing counterpart havoc, as we have already seen.

    Lastly, you pointed out that Greek banks hold 86% of their own government bonds to maturity, whereas banks in the rest of the PIGS, including Italy, hold between 24-47%. Is this 24-47 of their own sovereign debt (i.e. does the 34% number refer to Italian banks holding italian bonds or is it italian banks holding PIGS bonds without differentiating between countries?)

    Either way, this shows you just how ineffectual the stress test was for Greek banks over other peripheral countries.


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