Recently, the Universe smiled at me. I walked into a small second-hand bookstore, and found a signed, annotated, mint condition, first edition copy of Nelson Mandela’s autobiography “Long Walk to Freedom”. I rushed off to change the limit on my bank-card, and half an hour later, it was mine. And really, I cannot deny that the purchase was motivated by the prospect of making a return post Madiba’s mortem. In fact, in those 30 minutes that it took to change the card limit, I was plagued by the real fear that news of his death might break before I could get back to the store and seal the deal.
So it seems that I now have a vested interest in Mandela’s death. Is that a pleasant thought? Perhaps not. But then, I like to be pragmatic about these things. Investments are investments.
But despite my vested interest, would I go so far as to act on it? Well, no. That sounds like a lot of effort. And I’m sure it would cost more than any gain that I could make. Pragmatically speaking, of course.
Now what does this have to do with the Greek Debt Crisis? Well – it comes down to a question of vested interest. Up and until around 2005, the aim of investing was to reap gains when the market goes up, and limit losses when the market goes down. The market rewards you with gains when you make the right call on the market improving; and it rewards you with no losses when you make the right call on the market crashing.
Evidently, at some point, someone began to notice the logical inconsistency there. Essentially, you bet on the market going up, you stand to make money; you bet on the market going down, you sell off your investments, and you make no money at all (but you don’t lose anything either). And someone says “you know what, I also want to be able to make money when I call, correctly, that the market is going to crash”.
That desire sounds a lot like wanting to buy an insurance policy. For example, when I insure my car, I pay my insurance company monthly premiums, and in the event that I crash the car, they pay for the repairs or the replacement. That is: I am betting on my car getting damaged in an accident; and the insurer takes the other side of the bet, saying that I won’t. Or, at least, they say that with enough people paying car insurance premiums, it is statistically unlikely that enough cars will be damaged in order to make them make a loss.
So someone takes this idea and says, “You know what – that guy over there with the drinking habit – I reckon that he’s quite likely to have a car accident. Can I take out insurance on his car? I’ll pay you monthly premiums, and in the event that he crashes, you pay me the value of his car”. What is the problem here? We’re removing the requirement of ownership. In that situation, there is no limit to the number of insurance policies that can taken out on that car, other than the insurer’s willingness to write them.
And that, more or less, is a Credit-Default Swap (CDS). I take out insurance against losses on someone else’s investment.
Let’s take, for example, a 10 billion euro bond issue by the Government of Greece. I look at the fundamentals of the Greek fiscal situation, and I say to myself “you know, they’re probably not going to be able to sustain the schedule of repayments”. So I approach a financial institution, and enter into a CDS over those bonds. In terms of our arrangement, I pay an annual premium; and should the Greek Government fail to meet its schedule of repayments, the financial institution will pay me the full value of the bond issue. The key points:
- I never have to buy the bonds.
- I just pay an annual premium (a percentage of the value of the bonds issued – say 0.025%, or 2.5 million Euros) in return for the potential payoff of the entire bond issue (10 billion Euros).
- Any failure to meet the schedule of repayments (even if, for example, the Greek Government is a day late for one of its quarterly repayments) will result in the payout (these situations are known as “default events”).
- There is no limit to the number of CDS instruments over that bond issue, other than the financial institution’s willingness to grant them.
- I now have a vested interest in Greece’s default.
Now this seems to be a raw deal for the insurer. Why would any financial institution enter into these contracts? Well, for starters, governments almost never default on their debt, so the statistical risk of a default event is empirically low. Secondly, the gentleman doing the deal at the financial institution is probably going to be in line for a bonus every year – a bonus based on the volume of business he does, or the value of the premiums he brings in. Is he incentivised to avoid CDS transactions? Not at all. They result in a constant inflow of premiums, with very little historical outflow.
But this justification is flawed. The historical evidence for government defaults includes a time before Credit-Default Swaps. That is, a time without a vested interest in any one country’s default. CDSs were only created in around 2005, by investors wanting to bet on the failure of America’s mortgage-backed securities (investors who reaped their rewards in the Subprime Crisis). There is therefore a mismatch between the risk, and the justification for taking it on.
But now it is too late for that realisation to help. The CDSs were written. And now we find ourselves in a situation where an unknown number of investors hold an unknown number of credit-default swaps. All these people stand to gain in the event of default. It has been suggested that the number of CDSs written, if cashed in, could exceed the value of the world’s money supply.
It’s theoretically possible that Greece’s default could trigger the collapse of the entire world’s financial system. The Subprime crisis almost did – but that was before most investors saw the potential gains inherent in credit-default swaps.
The CDS may well be the beast that brings Financial Armageddon.
Someone needs to ban it indefinitely.
Once I’ve sold mine.
(As an aside, the practice of short-selling was and is a way of making money when the market crashes – but the potential gain is limited by the number of stocks available to be short-sold. In other words, there is a physical limit – the number of shares – to the potential gain).
Gareth Crosland January 25, 2012 at 19:47
Very interesting read. I never knew about this potential financial disaster relating to the Greek Debt Crisis.
Is the primary concerns of most people in the Euro related to these unknown number of CDSs or some other aspect? The reason I ask is because I have not heard this CDS view and its potential impact in any televised media such as SKY, BBC etc.Reply
Jayson Coomer January 25, 2012 at 22:12
I agree that it's strange that the CDS view is not mentioned in televised media – but I think it's mostly because CDSs are misunderstood, and their impact under-estimated.
If I'm honest, I think that the primary concern is the contagion that a Greek Debt default would cause. With the default, Greek Debt would instantly be downgraded to Junk Status. Any banks (including the ECB) that have investments in Greek bonds would immediately be downgraded as well. And with the downgrade, their cost of borrowing would increase, causing potential liquidity shortfalls for these banks when they roll their current debt. And as banks begin to fold under liquidity pressures, so the contagion spreads.
Perhaps it warrants another post?
Thanks for the comments, Gareth – I really appreciate the feedback!Reply
Gareth Crosland January 26, 2012 at 17:18
I think so – detailing the contagion effect of the Greek default and its effects on the rest of Europe.
Keep up the good work.Reply
Gareth Crosland January 27, 2012 at 19:43
Read this article. Very interesting. It seems to suggest Europe is less worried about triggering a credit event now to bring the CDSs into play than ensuring that all investors in Greek bonds take a write-off in an orderly manner.Reply
Jayson Coomer January 28, 2012 at 14:26
Hectic – that was awesome.
It'll be fun to see if they're right! I mean – 'fun' may not be the right word, but interesting anyway.
I'm writing something on contagion – but I guess that, if you accept as given that some CDSs will be triggered, you want to try and limit the number that will be. And if an orderly default prevents contagion from spreading through the other indebted countries and causing other credit events, then we're winning (relatively speaking)…Reply
Jayson Coomer January 29, 2012 at 22:04
The other viewpoint!Reply