We Need to Talk About Sovereign Credit Default Swaps
You’ve seen the movie. Some bankers become the proud parents of a new-born financial instrument. At first, little CDS seems like everything a parent could want – a hedge against the downsides of middle-class existence. But as CDS gets older, disturbing signs appear. CDS is too knowing, too negative – focused on the financial death of companies and countries, left cold by the positive, socially useful side of finance. Told in flashbacks, the movie hints at some terrible denouement, the ‘credit event’, where CDS shoots deadly arrows into the fragile heart of the financial system. There’s edgy camerawork, eerie music, flashing police lights: you know it’s going to be horrific.
Small wonder that countries keep getting bailouts, bankers get strong-armed into accepting ‘haircuts’ on their sovereign debt exposure – anything to prevent the dreaded ‘event’. Greece is a case in point. Financially speaking, the country is on life support. Its bonds smell as wholesome as Muammar Gaddafi. Allowing the Greeks to default on their debt, including that owned by the European Central Bank, would be an act of mercy. Politics dictates that this can’t happen, and one of the bogeymen trotted out to justify the politics is that event in which our scary CDS devil-child shoots its deadly arrows.
It’s not so much the face-saving deceit of this argument that bothers me. One expects nothing less of politicians.
Let’s start with the premise that the much-trumpeted deal between EU governments and the Institute of International Finance for a 50 percent haircut on Greek debt prevents financial Armageddon. If enough bondholders sign up to this deal, it will be deemed ‘voluntary’, meaning that CDS on Greece can’t be triggered and the dreaded event is postponed. Now I buy into the idea of Eurozone financial institutions not triggering contracts that protect investors for political reasons. Take this one for Germany, Deutsche Bank shareholders; bend over for La Patrie, Societe Generale and BNP Paribas shareholders. However, I don’t believe for a minute that the likes of J.P. Morgan’s Jamie Dimon would agree to something detrimental to his investors in order to keep Angela Merkel and the IIF happy. Dimon has already spent too much time on earnings calls talking up the CDS hedging of his bank’s sovereign exposure to reverse that position.
But fine. This is a movie, so let’s pretend that all the world’s financial institutions agree not to trigger sovereign CDS contracts on Greece, or Italy for that matter. According to some commentators, that’s game over for CDS. These are ‘insurance contracts’ that now won’t pay out, according to the boilerplate definition used by many journalists.
In the movie, it was a catastrophic misunderstanding by the parents of the problem child that led to catastrophe. And here, it needs to be said, CDS are not ‘insurance contracts’. They are mark-to-market derivatives, 90 percent of which have collateral posted against market moves, according to the International Swaps & Derivatives Association. As a result, in 2008 Goldman Sachs was able to suck money out of AIG until it almost went bankrupt. And in 2011, that’s the point to make about Greece: if you bought protection a couple of years ago, you’ve already seen that mark-to-market gain. You already have your collateral.
Suppose you’re a credit portfolio manager at Deutsche Bank and Josef Ackermann tells you that Greek CDS won’t be triggered. What do you do? You close out your Greek CDS contracts (the easiest way is to sell protection equal to the amount you have already bought) and keep the collateral, booking the profits against losses on Greek debt. There are plenty of people willing to do that trade, people who don’t believe that a 120 percent debt-to-GDP ratio is going to save Greece. A trading desk I spoke to last week was busily matching up these buyers and sellers.
That’s how CDS work. Is it a good thing? Maybe not. If everyone knew that they would have to take a haircut on their bonds, rather than collect on their hedges, maybe they would have enforced market discipline earlier. Maybe if the Basel Committee for Banking Supervision had fixed Basel III banking rules so that CDS risk mitigation didn’t qualify for capital relief, there might be a meaningful discussion today. But that discussion isn’t taking place. If we’re going to talk about CDS, we need to understand them first.