Looking for a way to turn the Greek debt crisis into a bigger mess? Try derivatives. Yes derivatives, again
I understand why the Greek debt crisis is a big issue in Europe. The European Central Bank holds about $200 billion in Greek debt. At least three French banks and some regional banks in Germany have enough of the stuff stashed in their portfolios that some technically bankrupt banks could be forced to declare actual bankruptcy. The wage cuts and tax increases that have sent tens of thousands of Greeks into the street to confront helmeted riot police deploying tear gas hang over workers in Portugal, Ireland, Belgium…
But why should the rest of the world care? Greece is the 39th largest economy in the world, according to the CIA World Factbook, once you correct its GDP for differences in purchasing power. That puts it below Nigeria, Venezuela, and the Philippines and just above the Ukraine. If any of those countries were teetering on the edge of default, would world financial markets blink twice?
Why should we care? Derivatives. The same toxic stuff that brought down Lehman Brothers and that was just a bailout away from taking down American International Group and, perhaps, the global financial system is at it again.
Here’s what Mario Draghi, who will replace Jean-Claude Trichet as head of the European Central Bank, said at his confirmation hearing on June 14. Who knows what the effect of a Greek default would be, he told the European Parliament. Sure, everybody who owns Greek bonds is insured in the derivatives market using credit-default swaps against the risk of default. But “who are the owners of credit-default swaps? Who has insured others against a default of the country? We could have a chain of contagion.”
In other words, according to this delightfully blunt-spoken Italian banker, three years after derivatives almost destroyed the global financial system, they again pose an unknown risk to global finances.
This to me is the most troubling aspect of the Greek debt crisis. We’ve wasted a crisis that took the financial system to the brink of disaster. We don’t have any better idea today of where the risk is because derivatives still represent a dark place on the map. Regulators in countries such as the United States that are trying to get a handle on the derivatives market are still months away from finishing their first draft—and I don’t know if they’ll be allowed to finish. On our map of the financial markets we might as well label derivatives “Here there be dragons.”
Remember what happened last time?
The investor that buys a credit-default swap is looking for insurance against a default of the underlying debt instrument. The seller of the swap offers a guarantee of some payment against that default.
In the run up to the collapse of the mortgage-backed debt market everybody was looking for this kind of insurance. Everybody wanted the extra yield that came with one of these bundles of mortgages, and even though they may have had doubts about the claim that bundling together some pretty risky subprime mortgages produced a low risk AAA-rated security, buyers were willing to swallow their worries because they could buy a credit-default swap contract that, in theory, transferred the risk to some other party. Even after paying the premium for the credit-default swap insurance these sub-prime mortgage-backed securities paid more than similarly rated government bonds.
At their peak credit-default swaps had a notional value of $62 trillion, according to the International Swaps and Derivatives Association.
“Notional” value because there really wasn’t any way to know what these derivatives were actually worth since there was no market for most of them. No one actually knew how good these swaps were as insurance either, because no one knew who the counterparties were to many of these swaps or how much of the risk they’d sold off to other parties in other derivative deals or how much collateral stood behind a swap ready to pay off if the insurance came due.
Outsiders didn’t stand a chance at valuing these derivatives or calculating their risk, of course, but it turned out neither did the players themselves. Insurance giant American International Group (AIG), for example, held a derivatives portfolio with a notional value of $400 billion before the crisis. In a December 2007 conference call the company said that a write-off of all its credit-default swaps rated A or below would produce a loss of just $421 million.
Nine months later the company was desperately looking to raise $80 billion to prevent a default on its credit-default swaps. The derivatives had tumbled so far in value that AIG needed to raise massive amounts of cash to pay to buyers of the derivative insurance it had sold and to put up more collateral to back its swaps. The U.S. government finally decided to provide the cash out of fear that an AIG default would send the value of other swaps plunging, wiping out who know whose portfolios, and rendering derivative insurance that other investors were counting on completely worthless.
The derivatives market is smaller today. The notional value of the U.S. credit-default swaps market is about $16 trillion. The notional value of euro-denominated swaps contracts is $8 trillion. $8 trillion, I might point out, is roughly two and two-thirds the size of the Germany economy.
The notional value of Greek credit-default swaps was about $85 billion in April 2010. That’s about twice as much as in mid-2009. That increase shouldn’t surprise you—after all how many investors would buy Greek 10-year bonds even with their 18% yield with the current high risk of default if they couldn’t lay off some of that default risk in the derivatives market?
Do we know who owns these Greek credit-default swaps? Not in most cases since efforts to create public markets for derivatives trading have only captured part of the total. Do we know the strength of these counterparties? Or how much risk they’ve sold on to other derivatives players?
When Mario Draghi talks about contagion, part of what he’s talking about is the ability of the derivatives market to transmit risk at blinding speed to unidentified financial players in high enough volumes to potentially turn them into a slag heap of collateral calls.
But that’s only part of the possible contagion. Estimates put the total for all sovereign credit-default swaps at somewhere around $2 to $3 trillion. A Greek default could trigger a repricing of the credit-default swaps on Irish, Portuguese, Belgian, and Spanish debt that could wreck the portfolio of some counterparty somewhere.
And a Greek default isn’t the only risk either. If Greece manages to restructure its debt in a way that didn’t trigger a default—say through a “voluntary” extension of the maturities of Greek debt by some bondholders—that too might lead to a repricing of credit-default swaps. Such a selective restructuring that didn’t trigger the insurance policy of credit-default swaps might lead some investors to conclude that the derivatives weren’t worth nearly as much as they thought they were. Insurance that doesn’t pay off has questionable value, after all. And that too could lead to troubles in some derivatives portfolio somewhere.
And it’s not like European financial institutions have a lot of cash to throw at any derivative crisis. The European Central Bank is estimated to be on the hook for $200 billion in Greek debt that it has bought to prop up Greek government bonds. A Greek default would put the European Central Bank hat in hand on the doorstep of not terribly sympathetic governments in Berlin and other northern European capitals in its own search for capital just at the same time as some European banks would be looking for capital and liquidity themselves.
The likelihood is that a Greek default or a credit event short of a default won’t hit a financial institution big enough to make a systemic difference hard enough to turn the current Greek crisis into a European or developed markets crisis. But the truth is that no one knows for sure. And when investors can’t figure out where the risk might lie or put a reasonable estimate on its dimensions, the financial markets get very, very nervous indeed.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , may or may not now own positions in any stock mentioned in this post. For a full list of the stocks in the fund as of the end of March see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/
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