Monday, November 7, 2011

Default Exposure

The European Pantomime

As each day goes by, the pantomime in Europe reaches new levels, with a 'firewall' that will not contain the crisis, a 'firewal'l that will encourage the spread of the fire, yet more crisis summits, and the farce of the Greek referendum that was then wasn't. Perhaps the most absurd part of this is the attempts at arranging a 'haircut' (so many metaphors) on Greek bonds that will not trigger credit default swaps, which is a form of insurance on debt default. This from Bloomberg:

Confidence in the credit-default swaps market may be undermined by the European Union’s plan to resolve the euro region’s sovereign debt crisis.
The EU said yesterday that it reached an agreement where banks will write down their holdings of Greek bonds by 50 percent. The International Swaps and Derivatives Association’s chief lawyer later said because the deal agreed to by the Institute of International Finance is considered voluntary, it won’t require firms that sold a net total of $3.7 billion of credit protection on Greece to pay buyers of the swaps.

“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” said Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros.
German Finance Minister Wolfgang Schaeuble is among European politicians who have expressed concern that the contracts have worsened the euro region’s troubles. Speculators can use them to benefit as a nation’s creditworthiness declines because the price of the insurance they offer rises.
There is something distinctly odd in this. First of all, this increases the likelihood of contagion, and the EU is seeking to force a haircut on the banks that hold Greek bonds, but at the same time is in a panic about the impact of sovereign defaults on the European banking system. Does this not seem odd, bearing in mind that some of the issuers of CDSs are US banks?

As the European financial crisis worsened during the first half of 2011, U.S. banks increased sales of insurance against credit losses to holders of Greek, Portuguese, Irish, Spanish, and Italian debt. Guarantees provided by U.S. lenders on government, bank, and corporate debt in those countries rose by $80.7 billion, to $518 billion, according to the Bank for International Settlements.
BIS doesn’t report which firms sold how much or to whom. Almost all of those guarantees are credit-default swaps, according to two people familiar with the numbers who asked not to be identified because they weren’t authorized to speak. Five banks—JPMorgan (JPM), Morgan Stanley (MS), Goldman Sachs (GS), Bank of America (BAC), and Citigroup (C) — write 97 percent of all credit-default swaps in the U.S., according to the Office of the Comptroller of the Currency. A credit-default swap is a contract that requires one party to pay another for the face value of a bond if the issuer defaults.
In other words, if CDSs were triggered, some of the pain would be passed on to non-European banks. Is this not the purpose of CDSs, to spread the risk more widely and reduce the exposure of individual institutions. The problem is that, the total exposure and the holder of that exposure is opaque, and we cannot be sure where, in complex networks, the real exposure lies:

A possible antidote is better disclosure about counterparty concentrations. Big banks aren't likely to do this on their own for fear peers won't follow suit. So it's time the Securities and Exchange Commission stepped in, calling for disclosures on counterparty concentrations and standardized information about country risks.
The big five banks mostly gave extra disclosure on their European exposures in third-quarter earnings. But each took a differing approach. The firms, aside from Goldman, did show how much CDS they had purchased against exposures to Piigs countries—about $20 billion in total. Lacking, though, was any detail about counterparties, other than vague assurances like it was purchased from "predominantly investment-grade global banks." Without more information, the protection is suspect.
Granted, banks would likely balk at providing detail on even high-level counterparty exposure. For one, they may fear this additional information could highlight how much risk rests in a small group of about a dozen or so big, global banks. And they will be quick to point out that the additional information they've so far provided has hardly helped reassure investors.
It is a certainty that central banks and the regulators in the US and Europe have a good idea about the concentrations of risk in the system, and they are no doubt briefing and driving the policy of politicians. This is all so opaque, and one can only suspect that the avoidance of triggering CDSs is yet again about 'too big to fail'. In other words, the world is being moved again by policy to protect large financial institutions and the 'investment-grade global banks' are investment grade only because they are backstopped by governments and central banks.Is this not shabby? Comments welcomed.....


  1. Yes, it is shabby, but politics and finance are a sleazy combination. Unbelievably large sums of money are at stake.

    Having watched this going on for years now, I can only foresee it going on for a whole lot longer.

    I guess the name of the game is to keep pushing the day of reckoning out into the future, whilst each individual financial institution manages its own position to minimise its long term loss whilst trying to maximise its short term gambles. I suspect its a game of pass the parcel.

    I expect the European pantomine to keep running until one countries electorate says 'cobblers to this' and defaults or pulls out of the Euro or both. It will have to be some kind of electorate driven event, as clearly the politicians will just try to keep the bailouts coming.

    Maybe the Greeks will be the first to get a chance in an election, but I suspect they love the EU and Euro an awful lot, as many of them have made a good living out of it for a few years. So, I don't think they will pull the plug but just keep fudging the numbers and bail out issue as staying in the Euro and its austerity package will be easier than going back to the Drachma and the austerity that will entail.

  2. Weird. Why would the Eurozone countries not want to share the pain with US banks? Best explanation I can hypothesise is that they would rather help known banks deal with a known haircut than allow pain to fall unpredictably within the international financial system, for fear that fear would then paralyse the whole system again. But surely that's too subtle for politicians trying to find any course of action at all that they can agree on?


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