Thursday, October 27, 2011

Some Dirty Pool Going on with Credit Default Swaps

Part of the reason for the recent market rally is because of the "announced" agreement with regards to the sovereign debt crisis, especially as it pertains to Greece (I think it is the fourth such agreement in the last year and a half).  It actually seems to be an agreement in name only as they've agreed about what they wanted to do but not exactly how they were going to do it (e.g. where will the funding come from exactly, which I would consider a very important detail).  And one aspect of the deal might actually lead to some nasty consequences down the road.  They've agreed that private investors need to take a 50% haircut on their sovereign debt instead of the 21% they mentioned previously (I pointed out why it would be inadequate here) and it looks like the International Swaps and Derivatives Associations (ISDA) has said that as long as the haircut is technically "voluntary", credit default swaps won't be triggered.  Now I don't know if the EU leaders have pressured the ISDA (maybe through threats of increased regulations of derivatives) or if the ISDA ate a brain tumor for breakfast but this decision is so horrible and counter-productive, I don't really know what to say.  It is sort of like you getting into a car accident and then the insurance company telling you they won't pay to fix your car because you were driving the car at the time (even if the accident wasn't your fault).  Imagine, if you will, that you are managing a giant sovereign bond portfolio that is hedged with credit default swaps, so that you can feel comfortable owning the debt through this crisis.  Well what this ISDA decision does is make you aware that instead of being 100% hedged with 0% default risk, you might actually be 0% hedged with 100% default risk (depending on what countries you own of course) and completely destroys any value you have placed in the credit default swaps.  This will lead you to quickly try to sell any sovereign bonds that you are worried about, exacerbating the current crisis, because without credit default swaps you have almost no effective way to hedge that risk (well until they create a new derivative class of course, but that could take years).  My guess is that over the next days, weeks and months you will see the yield of countries like Portugal, Italy and Spain (and even France) really skyrocket as the few people who felt comfortable holding their debt start to get far less comfortable.

Markets, despite what the protesters say, are based on certain rules and fair play.  There are trillions of dollars in equities, debt instruments, currencies and derivatives traded on a daily basis, many by market participants who don't know each other but trust that the rules will not change on a daily basis or at the whim of the powers that be.  A decision to make a 50% haircut on a bond not a default puts entire markets into question and really threatens the stability of the financial system much more than if Greece suddenly decides to go with the Drachma.   A lack of confidence in a certain market or group of markets (like Greece, Spain, tech stocks, etc.) is one thing, a lack of confidence in the actually function of the market itself is another.  The ISDA really needs to get its act together or there could be disastrous consequences down the road.

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