Did the International Swaps & Derivatives Association (ISDA) throw Europe into chaos? Is it responsible for causing Italy and other European nations' woes, for the sudden spike in southern European interest rates? It is an interesting question to explore.
The ISDA is an organization that few people know about. It is controlled by a small group of financial institutions who deal in derivatives. Collectively, the ISDA derivatives dealers have written well over $600 trillion worth of derivatives of various types. Great lengths were taken, during the negotiation of last month's Greek restructuring, to avoid triggering one type of those derivatives, commonly known as a "credit default swap" (CDS). We will ignore, for the moment, that Mr. Papademos, now the new Prime Minister of Greece, was head of the Greek central bank at the time when two well-known members of ISDA, facilitated that nation's entry into the eurozone, by helping to falsify its national debt level by the use of complex derivatives known as "cross-currency swaps." That is another story, for another day.
ISDA is an organization that sets common standards for over-the-counter (OTC) derivatives contracts, and establishes supposed "rules" to govern them. OTC derivatives are not traded on registered futures exchanges, but, rather, directly between financial institutions. Under ISDA rules, six events can trigger the obligation to make payments on credit default swaps -- bankruptcy, acceleration of the obligation, default on the obligation, failure to pay, repudiation or moratorium on payment, and a "restructuring" of the debt. The issue, in the case of Greece, was whether or not there was a restructuring. According to international law firm Mayer Brown, in an article for Practical Law Company, the ISDA rule is that a credit default event will be triggered when:
...the reference entity arranging for some or all of its debts to be restructured causing a material adverse change in their creditworthiness...
In other words, CDS issuers are supposed to pay when the buyer of protection faces problems receiving payments on the bonds it owns.
Several ISDA committees are supposed to fairly determine whether and when credit default swap beneficiaries get paid. The rules are the same internationally, but there are different determinations committees that are appointed regionally, with one for North America, another for Europe, Asia, etc. The voting members in Europe are Bank of America/Merrill Lynch (BAC), Barclays (BAC), BNP Paribas, Credit Suisse (CS), Deutsche Bank (DB), Goldman Sachs (GS), JPMorgan Chase Bank, N.A. (JPM), Morgan Stanley (MS), Société Générale, UBS, BlackRock, BlueMountain Capital, Citadel Investment Group, LLC, D.E. Shaw Group, and Pacific Investment Management Co., LLC. (PIMCO). Citigroup (C) and Royal Bank of Scotland (RBS) are non-voting consultative members. Most of the same big financial institutions have control of all the committees, although the actual people on the committees may be different.
Last month, Greek and other European leaders pressured financial institutions to accept a very unpleasant Greek debt restructuring. Most of the institutions that hold Greek bonds are not voting members of the ISDA committees. Unlike the voting members of ISDA, most bondholders are not politically well connected. They accepted the deal because their masters, who are the government politicos, were calling the shots. The institutions were forced to accept a reduction of 50% because governments presented the alternative as total default. Since most are not "protected" by CDS, that would mean a total loss. Like the scenario in the movie, "Godfather," it was "an offer they could not refuse." In structuring this deal, European politicos were obeying their own masters.
The ISDA voting members leaped on the excuse to declare Greek restructuring "voluntary." As a result, CDS holders did not collect any payments. In fact, instead of collecting payments, many received demands for additional collateral, if they were foolish enough to have purchased bonds on margin. Margin and collateral calls, in many cases, were sent by the same financial institutions that control ISDA, and which had just declared the Greek default to be a non-event. This process was part of what collapsed the futures brokerage firm, MF Global (OTC:MFGLQ).
In addition to being obligors on CDS contracts, some voting members of ISDA, like BNP Paribas, Societe Generale and Barclays, are also probably owners of a lot of Greek bonds. For them, the ISDA committee ruling may have been a wash, with no net benefit going either way. But, because so much secrecy surrounds bank obligations, we don't really know for sure. What we do know is that US banks and financial institutions increased credit default swap exposure on government, bank and corporate debt in Portugal, Ireland, Italy, Greece and Spain, by $81 billion to $518 billion in the first half of this year. Big US banks dominate voting on determinations committees, as illustrated by the membership roster described above.
A refusal to acknowledge that a credit default event happened saved these dealers a great deal of money. But, in the end, ISDA made a mockery of its CDS contracts. One might suppose that CDS contracts would, after this, be completely discredited. But, it is not so. While the derivative is now discredited as a hedging tool for smart investors, especially those who actually own the underlying bonds, foolish speculators will still fork over their money to the derivatives dealers, even though more rational folks will have already determined that casino-goers are not going to be allowed to win such bets. But, inveterate gamblers are addicts, and they will continue to frequent a casino, no matter how badly is cheats them.
In any case, the availability of cheap CDS "protection" for the first decade of Euroland's existence provided a perpetual bid for sovereign bonds, even though they were from infamously profligate sovereign sellers. The derivatives dramatically lowered rates. What is ironic is that cheap CDS became far more important as the eurozone's troubles mounted, but the cost has skyrocketed, especially after the Greek deal. Speculators can no longer buy bonds, and conservative cash buyers have decided to stay out of the market. The bid on southern European bonds has became dependent upon the ECB, and Mom & Pop investors in the individual nations.
Even the folks who had bought cheap CDS protection in "the good old days" are selling. As a result of the Greek debacle, few still believe that their CDS will provide any protection at all. That has exacerbated a big rise in European interest rates, making refunding by European sovereigns ever more difficulty. The problem is that, like their American counterparts, Southern European politicians liked to perpetually roll over debt, and never repay it. That means that old debt is repaid with new debt, over and over again, in a Ponzi scheme that has no end. The only cost is the rate of interest, which, until now, was very low even for known profligates in Europe.
With CDS dependent buyers trying to move out of the euro-bond market as quickly as they can, it has become increasingly clear that the size of the debt is so large, and the cost of endlessly rolling over now so high, that profligate sovereign debtors can no longer afford to endlessly roll it over. This process of so-called "contagion" began with the self-dealing and political influence peddling by big derivatives dealers. The ISDA players will always be ready to accept big payments for so-called "protection" from anyone foolish enough to pay them. But, when push comes to shove, they will find a way out of paying for sovereign defaults in Europe. The Greek deal has given them a roadmap.
Think about MF Global. A primary dealer of the Federal Reserve. One of America's most credit worthy counter parties. A "very reliable" counter party. Very reliable, that is, until just a few days before its demise. MF Global is now bankrupt because of collateral calls on some of its leveraged southern European bond positions, and part of that, no doubt, is because the ISDA derivatives dealers used their political influence to find a way to avoid paying for the Greek credit default event.
The derivatives dealers claim that their total "net" liability on Greek debt is only about $3.5 billion once "hedges" are netted out. Baloney! If that were true, it is unlikely that they would be willing to risk their entire business model, and create other sovereign defaults by refusing to pay on Greece. The actions of ISDA dealers are a desperate effort to avoid paying up on what is a $74 billion "gross" notional obligation. My suspicion is that most of their so-called "hedges" are, in truth, bogus deals with insolvent financial entities willing to sell cheap "protection" because they never intended to pay off on it. They were probably designed so that the dealers could show that their deals are "hedged" on the books, and avoid the scrutiny of their national regulators. The ISDA dealers must know that the bogus hedges will fail, if ever tested, and that the true liability is many multiples of $3.5 billion.
Be that as it may. No one trusts CDS contracts anymore, except those who want to own them purely for speculation. Entities that really need "protection" are now simply selling their euro-bonds, and aren't bothering to try hedging with credit default swaps. In a more perfect world, with smarter people in place, bond buyers would have known, from the beginning, that the derivatives dealers are incapable of meeting the full requirements of the promises they've made. People who buy southern European bonds should have been demanding high yields for many years, or looked elsewhere. But, because of credit default swaps, there were too many investors at the margins, thinking they could hedge risk by purchasing CDS contracts, and whose purchases dramatically reduced yields.
Meanwhile, the innocent citizens of southern Europe have been handed a huge problem. Yes, they live in profligate states, but they are not morally responsible for the irresponsible actions of their government. But, they will end up financially responsible. Citizens are between a rock and a hard place. There is now widespread fear that all southern Europe will eventually default, and that is going to continue to press rates upward. Governments will raise taxes or reduce services. If they decide to default, no one at all will lend to them anymore, and they will be forced to become self-funding, meaning higher taxes and lower spending. The greatest Ponzi scheme in the history of the world is in the process of ending, not only in Europe, but in America and Japan as well.
It is amazing how supposedly "sophisticated" investors can be so foolish. Savvy and conniving derivatives dealers took advantage of this foolishness. They sold credit default swaps, interest rate swaps and a large number of other derivative gimmickry to a bunch of suckers. But, by helping those dealers avoid paying off, European leaders have caused much higher interest rates, and unintentionally helped the world wake up, all to the short-term detriment of the eurozone. People now understand that risk cannot be offset by a bogus easily manipulated contract with a derivatives dealer. When push comes to shove, the obligation will be avoided through political manuevering.
Most troubling is the fact that the current seemingly "high" rates in Europe will almost assuredly draw in a lot of unsophisticated "mom & pop" type investors, who remember the 1980s. Such investors will probably think that the high rates in southern Europe are a repeat of that era. But, the level of debt is so much higher now that governments cannot pay such high rates in the absence of monetary debasement and high inflation, which has not fully run its course. The high interest rate 1980s were presaged by the Great Inflation of the 1970s, during which a huge amount of paper money was printed, and all paper currencies were devalued worldwide. Nations must first engineer a deep monetary debasement and it hasn't happened yet. In other words, getting a mere 7% yield on 10-year bonds, from nations like Italy, Greece or Portugal, means getting a very low rate of return, if the buying power value of the euro (or lira/drachma/etc) is devalued by 70%.
Most interesting is the fact that the politicized Greek restructuring deal that caused this acute contagion is not even finalized. But, the manner in which it was done has, nonetheless, caused the market to panic. Bond markets have reacted by telling us that the European Monetary Union (EMU) is over. Interest rates now being demanded equal or exceed levels that existed prior to 2000. By "cheating" customers, the big ISDA derivatives dealers have accelerated the demise of euro-land. It probably would have ended, anyway, but they've sped things along. Separate currencies are almost certain, now, for northern Europe, at least in the opinion of this writer.