Saving The CDS Writers: Takeaways From The Euro Deal

by: Venkata Subbu

How to make sense of the Euro deal - Euro debacle? American debacle?

Greece is bankrupt and everybody knows it. Why did this mean the breakdown of the Euro or the Eurozone? After all, the amount in question (approximately 471 billion euros) could easily have been handled with a partial or complete default, and even the magnitude of the agreed writedown (50%) was anticipated well in advance and priced in (the markets were valuing Greek debt at 40%). The debt markets left to themselves would eventually have come to this resolution. The Greek government would have had problems getting loans and paying salaries, maybe even ceased to function, and would have been tossed out by its people as a result. Greeks would leave in droves - as is already happening. However, Greece would not have had to leave the Eurozone - although they might have in a fit of pique - as the Euro accords explicitly prohibit bailouts of governments, but have no provision to expel a member.

The big part of the Euro deal seemingly was to make the debt reduction "voluntary" - so that the insurance provisions of credit default swaps (CDS) would not be triggered and no payout would be due even though Greece needed to default. The ostensible reason was to prevent a chain reaction of failures. But apparently the total CDS obligation does not amount to more than 40 billion euros - something that governments can relatively easily handle. Also note that they did not care that Italy came up short, and produced only a letter of intent!

One (paranoid?) interpretation of the events is based on Americans owning the insurance obligation of the CDS. The gestalt of all the behaviour and facts seems to fit. Guess who wrote most of the CDS? - Americans! 470 billion is a huge amount for private financial institutions. Also, there was a huge spike in the price of Volkswagen shares in 2008 - after the big drop in the S&P. Somebody really got taken that year, and some Germans probably made off with a huge bundle. Rescue and retribution were required. So Merkel was called in, and told what she needed to accomplish. In June of 2009, Merkel left Washington with encouraging noises about the world depending on her leadership on the financial crisis. Boy, did she deliver - in her own style and not compromising her principles. A first attempt resulted in only a 21% writedown, which was wholly insufficient. The second attempt was much more realistic. A 4am decision came after she threatened to go for a 100% default, which the market was not pricing in. She had prepared for the possible fallout of having to execute on the threat by going to her parliament (more than once) and convincing them to provide the backing she needed. Part of the convincing process was to talk of possible war in Europe, which she could have been threatened with. Libya could have been the show of seriousness.

Another possibility is that Germans underwrote the insurance portion of the CDS written by the Americans, and not having the insurance trigger was in their own interest. American banks are very good at getting somebody else to be the bag-holders. In fact, German banks were real bag-holders of the American mortgage mess. Another possibility is that the Greek debt was mostly owned by some particular "bad" private investors who are now getting their comeuppance. In any case, an impressive performance so far by Chancellor Merkel.

One should expect further chapters in this saga. Merkel explicitly asked her parliamentarians to be careful about what they said, as there were a lot of moving parts to her plan, and a lot depended on the right things happening at the right time. She herself is only calling this a beginning. Note a side effect of the deal - if you fund a sovereign government as a private investor, you cannot count on CDS being honored. What this is going to do is convince many investors holding such sovereign debt covered by the CDS to sell their holdings at a reasonable price (established at 10% above the market by this deal), and convince the buyers to hold it naked - without CDS coverage, since that is pointless. Where it actually trades is immaterial - remember it is still "voluntary." After enough such transactions have taken place, the CDS contagion risk is effectively eliminated or at least manageable, and the sovereigns can do what they really need to do - default unilaterally - at a price that actually works. The EFSF insurance is there as a mechanism to convince the buyers to buy and will only cover the differential between the truly anticipated writeoff and what is being posited right now.

What are the take-aways for the investor, who is most unlikely to be into sovereign debt? First, Greece is likely to declare a hard default sometime within the next two years. If that is an involuntary writeoff of less than 60%, or a voluntary writeoff, the crisis has been managed well, and markets can recover sharply after the declaration. Italian debt obviously seems less of a concern for people worried about the markets. That is not to say that they won't declare a default (although I dont think they will), but just that we should not be worried about serious collateral damage if it happens. If the Greek writeoff is more than 70%, then threats have been executed, and further pain lies ahead, for both Greeks and other parts of the world.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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