Sunday, February 26, 2012

The Greek Issue

If you've been following the European debt situation lately you know the whole Greece issue is a constant 'on-again-off-again' soap opera as to whether an agreement has been reached to resolve the crisis.

And after the latest 'agreement', Greece is back in the news requiring more money.

It raises the spectre of whether or not a Greek default will occur.

Some have speculated there will be a default and it will destroy the Big 5 US Banks because of their derivative exposure.

That won't happen, but you may be surprise to find out why... and how this is just the tip of the iceberg on the European debt issue .

No one is really sure what happens in the credit default swap CDS markets.

No one really knows how big this market is, who the counterparties are, and, worst of all, whether the CDS contracts will actually trigger in what many would consider a default.

I say "what many would consider a default" because you are going to see any agreement in this issue ruled 'not-a-default'.

Up to now, most of the media discussion has centered on potential contagion among the banks as most of the Greek sovereign debt is held by the European banking community (and numerous hedge funds).

But the real fear amongst those who follow the situation is that the real concern lies in the area of credit default swaps (CDS).

The swaps are insurance policies, individually written, that basically say - if Greece defaults, we’ll pay you what Greece should have paid you.

Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.

What is known is that the Big 5 US Banks have sold the vast majority of this insurance, insurance which has been a cash-cow for those banks and largely responsible for those obscene Wall Street bonuses we hear so much about.

As Greece debt came up for sale, Banks and others looked at the very high and attractive yields on those Greek bonds and salivated as they bought them up.

As for the risk involved?... well, they bought insurance to protect themselves.

Then the 2008 financial crisis hit.

As the world wide economy imploded, the house of cards of sovereign debt in Europe began to collapse.

Portugal, Ireland, Italy, Spain and Greece (the PIIGS) were at the forefront of the crisis.

And lately Greece has been getting all the attention.

As negotiators on the Greek debt problem attempted to work out a solution to Greece's debt crisis, they asked the debt holders to agree to take, first 70 cents on the dollar for the debt owned to them and now 50 cents.

It was termed a 'haircut' on their investments (cutsie way of saying you're going to lose money).

But would that 'haircut' trigger their Credit Default Swap (the insurance they bought to protect them if Greece didn't pay back the full amount of the bond)?

On the face of it, it seems pretty clear. They have CDS insurance to ensure they get all their money back, Greece can't pay, insurance will cover the difference - right?

Well... not so fast.

Five of the largest US banks control 97% of all the credit default swaps.

And the total amount of these swaps and derivatives is in the hundreds of Trillions of dollars (yes... that's Trillions with a capital 'T'). JP Morgan alone holds over $60 Trillion in these derivatives.

Jim Sinclair, a precious metals and commodities trader since 1977 who has worked as am Executive member in two major Wall Street firms on the New York Stock Exchange, has discussed this issue in depth. Since the five largest US banks control 97% of all credit default swaps, a demand of payment on those derivatives would instantly wipe out these financial institutions.

Therefore it is imperative that any 'agreement' on how to deal with these bonds (and Greece's inability to deal with not paying them) cannot be determined a 'default'.

Enter the International Swaps and Derivatives Association Inc (ISDA). This is a trade organization of participants in the market for over-the-counter derivatives. Its membership consists of derivatives dealers, service providers and end users and they are the organization who make official, binding determinations regarding the existence of "credit events" and "succession events" (such as mergers), which may trigger obligations under a credit default swap contract.

In short the ISDA are the people who determine whether a credit event is a default or not.

The only problem is that the ISDA is heavily influenced (if not largely controlled by) the very big 5 US banks who hold 97% of the credit default swaps that are in question here.

If the ISDA rules that a 'credit event' (or default) has occurred in the Greek issue, the big 5 US Banks will be insolvent and wiped out. Wiping out these banks would wipe out the US Banking system.

Therefore you can be rest assured the ISDA will NEVER allow a 'legal' default on this debt.

That's why you keep hearing about negotiations on the Greece issue where bondholder's are being forced to accept 'haircuts' on their bonds.

The contention is that if the bondholder's "accept" the offer of 50 cents on the dollar, they make the event voluntary and it will not "trigger" the CDS payout.

These requests for a 'haircut' have caused lots of folks to ask for a ruling from the ISDA (the ruling group on CDS contracts). If you "accepted" an offer with a gun to your head, was it really voluntary?

Naturally the ISDA will rule that it is and therefore the CDS contracts are not triggered.

As Jim Sinclair contends the bondholders could be forced to accept 0%, the ISDA will never rule that a default because the big 5 US Banks cannot be placed in a position to pay out this insurance.

For those who think Greece will default later next month, it's not going to happen - legally happen that is.

The bondholders may be forced to lose everything, but the Big 5 US banks won't be forced to pay out on these derivatives and CDS contracts because the ISDA will never rule this issue a default.

The real focus is on what comes next.

This is what you should be watching in Europe.

In 2008, AIG had sold Credit Default Swaps (CDS) on Credit Default Obligations (CDOs). CDOs defaulted and AIG had to pay. AIG went broke. The counterparties to the CDS were Goldman Sachs, JP Morgan et al and had to be made whole on their losses that they thought were insured by AIG.

It was a crisis which could have brought down the US banking system.

In response the US Government intervened and funneled TARP cash thru AIG to Goldman Sachs, JP Morgan et al to cover losses

IN 2012, Greece is about to default, just like the CDOs of 2008.

The ISDA (controlled by the Big 5 banks) will rule that any haircut on Greek bonds is not a default. Therefore the Big 5 Banks will never have to pay off on CDOs bought by Greek bondholders.

But the Greek bondholders, who thought they had principal insurance, are now screwed and are left holding the bag.

This is what caused MF Global to go under when the first Greek 'haircut' was not ruled a default.

Those Greek bondholders (the big Euro banks, big Euro govts, big hedge funds) will now be insolvent. They are going to require massive capital injection.

As those CDS contracts do not kick in, the next phase begins to unwind.

What good is insurance that doesn’t pay off? Does it mean all CDS insurance is useless? Who will be the next to fail because the insurance they thought was protecting them isn't going to pay out?

As you have read on this blog ad nauseum. The 2008 Financial Crisis was a financial earthquake, the repercussions of which many of us still do not understand nor appreciate.

That's why the big 8 Central Banks of the world have been involved in another round of massive money printing - to try and save Greek bondholders. And the level of money printing has only just begun.

As I have said, we are still only beginning to realize how profound and far reaching the 2008 Financial Crisis really is.


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  1. Gonzalo Lira says it's going to be a default. I was surprised to read that. From what you are saying... I think he might be jumping the gun... esp as the Fed can lend endless amounts of USD to the ECB.... which will funnel its way through.

    ISDA is the managing group... and cahoots with the banks... but, in a contention... could it simply go to courts after a deep haircut??

    Also, I thought that deals could be blocked if there are enough votes against from the bond owners.

  2. This CDS non default situation reminds one of the non recognition by sovereign goverments, that their debt will never be repaid. Like Jim Sincair says the can will be kicked down the road in the form of QE to infinity ie. money printing.
    CBs have printed $10T in the last year and the consequences of this ongoing can kicking will be the end of the world as we know it. My father drilled into me that you " can't make candy out of horseshit", but many don't pay attention.