Friday, January 20, 2012

More myths around Greek CDS trigger risk

Significant misperceptions around Greek CDS triggers continue to persist.
WSJ: Since CDS function like insurance for debt, sellers of the protection pay buyers when a qualifying credit event, such as a default, occurs.
Again, CDS is not like insurance because it's an actively traded mark-to-market instrument.
WSJ: Hanging in the balance is the reputation of CDS as an instrument for hedgers and speculators--a $32.4 trillion market as of June last year; the value that may be assigned to sovereign debt, and $2.9 trillion of sovereign CDS, if the protection isn't seen as reliable in eliciting payouts; as well as the impact a messy Greek default could have on the global banking system.
It is true that the legitimacy of sovereign CDS settlement has been called into question because of the ability of governments to influence the "event of default" and conflicts of interest around the ISDA Committee. However the impact on the "global banking system" of Greek CDS triggering is minimal because banks who wrote protection have already marked these positions to market (as required by the US GAAP and IFRS).

By not triggering CDS, some have argued, the evil "speculators" who bought protection to bet against Greece will be punished because they will not get paid. And that supposedly would discourage others from "betting" against periphery sovereigns going forward. This is another misnomer because these so called speculators already made their money - they don't need to wait for the CDS settlement or maturity.

CDS holders who wanted to take profits simply sold their protection in the same way that an equity put holder can sell her put without exercising it and still make money when a stock drops. In fact some of the CDS holders have been taking profits causing Greek CDS to tighten some.

Greek 5-year CDS spread equivalent (Bloomberg)

Plus "betting" against a sovereign does not require a CDS.  Shorting government bonds in the repo markets is even easier than using CDS because bonds are usually more liquid. A repo agreement is simpler to set up than an ISDA agreement.  One can also achieve comparable or sometimes better  leverage in the repo markets to what one would obtain using CDS. In fact that's exactly how MF Global leveraged their sovereign bond positions.  So this whole concept that CDS somehow affords magical leverage capability unavailable elsewhere is a myth.

Another issue that continues to spook some people is the idea of counterparty risk.
WSJ: While the net volume of CDS outstanding is small at $3.2 billion, the gross amount--referring to the daisy chain of CDS bought and sold in the aggregate across financial market participants--tops $70 billion. If one of the those trading parties can't make good on its financial obligations, it could shake confidence in the system very quickly with potentially disastrous consequences.
Again, CDS is not like an insurance contract - in fact it trades more like futures. That means that counterparties are subject to variation margin which they post on a daily basis.
WSJ:... 93% of respondents to a recent International Swaps and Derivatives Association survey said their credit-derivatives trades were subject to collateral arrangements during 2010, which would cushion the blow.
During 2011 that proportion increased further with even some of the stronger banking institutions in Europe forced to post margin.

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