Innovation/Global Risk

  Oops!  Europe Stumbles Again! 

EU’s Version of “Days of Our Lives”

By Shlomo Maital

 

 Remember those terrifying three letters, CDS (credit default swaps), that destroyed AIG and hurt Citibank and nearly ruined the world?  Recall that CDS’s are not swaps at all, but ‘insurance’ against default on bonds; they bore a premium of about 2% of bond face value, but the risk turned out to be far higher than 2% and wrecked the companies that sold such ‘insurance’ mistakenly. 

  Well, CDS’s are still threatening the world. It turns out that the deal with Greece, to slash Greek debt, is in danger. The core of the deal is a ‘voluntary’ agreement on the part of the private banks holding Greek govt. bonds to forego about half of the debt and erase it.  Problem is, what does ‘voluntary’ mean?  If the banks really sign on the dotted line, agreeing to such a deal, their losses on the Greek bonds are not insured by the CDS’s.  If they don’t sign, they collect CDS insurance.

    Why? Well, if you burn your house down on purpose, you don’t get the insurance money, right?   But on the other hand, if the Greek government simply decides unilaterally not to pay half the debt, without the voluntary agreement, then the CDS insurance is indeed payable.  So the private European banks (including huge banks in Britain, France and Germany) face the terrible dilemma of agreeing to write off half the Greek debt,  and lose the CDS insurance.   And the amounts are tens of billions of euros.    You might think, who cares?  If the default is voluntary, the banks lose; if not voluntary, the banks lose too.  This is not the case. If it is involuntary, they collect insurance.  How many of us would willingly tell the insurance company not to pay us, if our insured house burns down? So the private banks have a huge incentive to let Greece default unilaterally.

   Moreover, no-one knows for sure how much the CDS insurance is worth or who holds it, because the CDS market is unregulated. (Remember: That’s why they called them ‘swaps’, because under a loophole in American law, ‘swaps’ are by definition unregulated).  So there is an enormous ‘second shoe’ waiting to drop, if Greece does default unilaterally.  It was this second shoe that caused the American credit market to freeze – banks refused to lend to other banks, because they were unsure how large the counterpart banks’ CDS debt really was.   

   Stay tuned, sports fans.  This drama is ongoing.  The European Union is a better soap opera  than Days of Our Lives..and may be longer lived, too.  (Days of Our Lives is one of the world’s longest-lived scripted TV programs,  airing nearly every weekday in the United States since November 8, 1965 – 46 years!)

    Footnote:  Good old Mario Draghi at the European Central Bank just announced round two of his “All the Money You Want” program, and 800 banks are expected to borrow $713 b. (in euros), compared with 523 banks who borrowed some $647 b. in the first round.   But remember: Draghi wants collateral.  Greek bonds probably don’t qualify.