THE BASIS POINT

Is Greek CDS Exposure Really Just $3b?

Here’s a good excerpt from John Mauldin’s most recent newsletter explaining two important things:

(1) How the International Swaps & Derivatives Association (ISDA) is involved in making decisions on credit default swap payouts, and

(2) More detail on the $3b in estimated net credit default swap payouts being paid out. They key word is ‘net’.

The ISDA (the International Swaps and Derivatives Association) declared today that Greece is in official default. This is a derivatives-industry committee of 15 members, representing the largest banks and derivative buyers – all the usual suspects. I started to write last week about their hesitancy, but it was very technical and I thought it likely they would issue the ruling they did this week. There are a few things we should note about this decision.

First, there is a widespread misunderstanding that the ISDA is the final answer to whether a nation is in default. The correct answer is, it depends. Credit default swaps are contracts between two private parties. The actual original contract is the governing document. While most contracts named the ISDA as the final arbiter of default, there are many that did not. Some experts told their clients there was a problem with choosing a self-interested industry group to be the final judge, and were very specific in their contracts as to what constituted a default. (Thanks to Janet Tavakoli, who spent an hour late one night patiently explaining the arcana and minutiae of credit default swaps. She literally wrote the book – and not just one but three of them – on swaps.)

It does not take a finance major to understand that if you do not get your money paid back to you, there was a default of some kind. If the ISDA had not confirmed a default by Greece, they would have ceased to be relevant in any future contracts that were written. It will be interesting to see how contracts are structured in future.

Secondly, the number that keeps showing up in the press is that there are only $3 billion of credit default swaps on Greek debt. That is only half true. The reality is that there is a NET $3.2 billion of CDS on Greek debt. The total or GROSS amount of swaps written is estimated to be about $60-70 billion (Dan Greenhaus, Chief Global Strategist, BTIG). This is in the 4,323 contracts that are known about.

Of the net exposure, the loss is likely to be less than the $3.2 billion, unless Greek debt goes to absolute zero. But that does not tell the whole story. For instance, just one Austrian state-owned “bad bank,” KA Finanz, faces a hit of up to 1 billion euros ($1.31 billion) for the hole Greece’s debt restructuring punches in its balance sheet. That loss, which will be borne by Austrian taxpayers, is someone else’s gain. The net number means nothing to them – they lose it all, over a third of the expected total loss.

Every bank and hedge fund, insurance company, and pension fund has its own situation. Care to wager that the larger banks won’t win on this trade? My bet is that there will be $30 billion in losses, out of which maybe someone will make $27 billion in gains.

Will the counterparty that holds your offsetting CDS be able to pay? Will all taxpayers be so accommodating as Austria’s? Does anyone think that taxpayers will bail out a hedge fund that cannot pay its debt, if it sold protection and has to default?

Would that it was “only” a $3 billion loss spread among the largest losers. That would be trivial in the grand scheme of things. Will Greece really stress the system, as it was stressed in 2008? The answer is, not likely, since European taxpayers have found €100 billion to cover the debt and the ECB has printed over €1 trillion, which has postponed any debt crisis for the immediate future. But the question that we must ask in a few paragraphs is, how many more countries will have to restructure their debt?

Read Mauldin’s whole piece