Can Greece CDS Trigger A European Lehman?
I will try to keep the hyperventilating to a minimum in this post. However, as summer approaches, many are saying a new European-focused credit crisis is taking form with Greece at the center. At issue is whether Greece can survive an austerity program without defaulting in a way that causes losses to metastasize throughout the global body financial. As with Lehman Brothers in 2008, the issue is not only about Greece itself, but the knock on effect for other debtors and the losses of creditors in an interconnected financial system.
There are a few threads from today that I want to pull together here but let me start with this one:
Credit Default Swaps
There has been quite a bit of buzz – at least in the blogosphere and in my circles – surrounding CDS exposure to Greece. Credit Default Swaps or CDS are financial derivatives which act like an insurance contract against the risk of default. CDS contracts are one of those areas Warren Buffett has labelled financial weapons of mass destruction and were the reason AIG, once the world’s largest insurer, imploded in 2008 after Lehman Brothers filed for bankruptcy. See, for instance, Why was AIG rescued after Lehman had failed? from September 2010 and Geithner urged AIG to withhold information from January 2010.
The reason for the buzz is that (contrary to my earlier thinking) it seems possible that even a soft restructuring for Greece would trigger CDS payments. That is the official line of some of the ratings agencies. So the question naturally becomes “who’s holding the old maid?”
Earlier today, I picked up on one comment relating to this at the blog “NAMA Wine Lake”:
UCD economics professor, Morgan Kelly’s article in the Irish Times last month appeared to reveal for the first time that a hitherto unknown player in Irish economic affairs, US Treasury Secretary Timothy Geithner had played a pivotal role in the IMF/EU bailout negotiations last November 2010. According to Morgan Kelly “The deal was torpedoed from an unexpected direction. At a conference call with the G7 finance ministers, the haircut was vetoed by US treasury secretary Timothy Geithner who, as his payment of $13 billion from government-owned AIG to Goldman Sachs showed, believes that bankers take priority over taxpayers. The only one to speak up for the Irish was UK chancellor George Osborne, but Geithner, as always, got his way. An instructive, if painful, lesson in the extent of US soft power, and in who our friends really are”.
This came as a major revelation. And since the publication of that article, Taoiseach Enda Kenny came under pressure to discuss the matter with President Obama on his whistle-stop visit later in May, and yesterday Tanaiste Eamon Gilmore who is in Tanzania and met there with US Secretary of State, Hilary Clinton, was asked if he had brought up the “matter” with her.
But what “matter”? I suppose we want to know why someone from the US would interfere in a bailout for Ireland. If that is what we want to know then Wikileaks has already provided the answer apparently. In their release of US State Department cables, there is one which reportedly seems to explain exactly why the US had a keen interest in bondholders in Irish banks being repaid : Secretary Geithner was concerned that if Ireland refused to repay bank bondholders then, in the words of Britain’s Telegraph “that could have spread contagion to the entire European system, to which American-backed “credit default swaps” were exposed to the tune of €120bn” (Wikileaks appears not to have published any cables beyond February 2010 on its website, and presumably this cable from Secretary Geithner is dated towards the end of the 2010, so an attempt will be made with the Telegraph to get the source cable and this post will be updated with any response).
These rumours of US exposure to euro zone periphery CDS are not new. For example, in February 2010, I asked Is AIG the main CDS insurer for Greek government debt? Since then, I have not received any information confirming or denying this. The CDS market is too opaque to know where the landmines are, something that added to the sense of panic in 2008.
When discussing who has Greek CDS exposure in the US by e-mail today, I received these responses from those plugged into this issue:
- If Streetlight/BIS have it right, one wonders why Geithner and the Bernank have been so quiet on the eurozone front. They should be weighing non-credit event solutions. With all the new found religion on macroprudential surveillance after 2008, is it possible the US CDS exposure is off their radar screen? Hard to believe, since BIS staffers would have raised a flag once they saw this – unless the decided it was a necessary evil to spread the damage and keep the French and German banks from rapid decapitalization once defaults started to spread.
One e-mail pointed to this article in the New York Times:
According to a recent report by Fitch, as of February, 44.3 percent of prime money market funds in the United States were invested in the short-term debt of European banks. Some of those institutions, like Deutsche Bank and Barclays, do not have dangerous Greek exposure. But some of those funds also hold shares of French banks like Société Générale, Crédit Agricole and BNP Paribas, which do have significant Greek bond holdings — about 8.5 billion euros, or, in the case of BNP and Société Générale, about 10 percent of their Tier 1 capital.
This month, the president of the Federal Reserve Bank of Boston, Eric S. Rosengren, warned that the large share of European banks in American money market fund portfolios posed a Lehman-like risk if, in the wake of a default in Europe, panicky investors took their money out all at once.
“Money market mutual funds have the potential to be impacted should there be unexpected international financial problems emanating from Europe,” he said in a speech at Stanford. "
But, according to another friend, some market players think US banks have reduced exposure significantly since the Q4 2010 BIS data were available. So, again, it is still unclear what the exposure is. But CDS are moving a lot in the euro zone periphery. Portugal, Ireland and Greece are at records of 763, 732, and 1612 respectively. If we see Greek CDS triggered, there will be panic.
What about a Greek default then?
I am still in the soft restructuring camp as I said on CNBC and the follow-on post last month:
An involuntary default would clearly be messy. I don’t see this scenario as likely, and it certainly won’t happen in 2011. Instead, I anticipate a soft restructuring followed by a certain amount of political dithering, which will create contagion that forces a hard restructuring (aka ‘soft default’) down the line. This will be “somewhat messy”.
The potential for CDS to be triggered even in a soft restructuring changes the calculus immensely, because that means losses will immediately be crystallized rather than spread out over a number of years as financial institutions recapitalize. We shouldn’t underestimate the difficulty this would create in money markets.
What does this mean for policy makers then?
- If CDS are not triggered by a soft restructuring, then we will see a bond exchange for Greece that extends maturities and cuts rates.
- If CDS are definitely triggered by a soft restructuring (maturity extension and interest reduction), then governments need to get comfort on the exposure to CDS and Greek debt by their domestic institutions. If the exposure is manageable all around, the soft restructuring can proceed. If it is not, then another bailout from the EU/EFSF/IMF facility is coming – followed by recapitalizations in anticipation of an eventual restructuring.
The CDS problem adds a whole level of complexity to the sovereign debt crisis in Europe. In my view, a CDS trigger could produce a Lehman-style event, yes. Moreover, only a hard restructuring – meaning principal reduction would actually have any meaningful impact on peripheral CDS or interest rates. So, I expect the euro zone periphery to continue to remain under stress until we reach that point. The policy response and appreciation of the CDS variable will be crucial in limiting downside risk.
I will be on BNN tomorrow at 12:30 EDT discussing this and other issues with presenter Howard Green and Philip Coggan from the Economist. It should be interesting. So tune in.
I suspect that the US banks still have substantial liabilities to CDS as the intervention of Giethner will confirm. I suspect that the losses would be enough to wipe out the main investment banks again. What will they do then? Another bailout would be a mistake.
I can’t say what kind of exposure is still there given the time people have had to dump exposure or hedge it. But clearly, the US is concerned. That is certainly why Tim Geithner intervened in the Irish situation. The problem is that the situation in Greece is untenable. This kicking the can solution will lead to disaster. If austerity is rejected and we do get a default in Greece afterwards, this will be plain.
‘This kicking the can solution will lead to disaster. ”
Agree. Absolutely.
But is is hypocritical to expect another to take the same medicine that you refuse to take.
The US will rue the day for a long time that it refused to “take its medicine” at the time.
I suspect that the US banks still have substantial liabilities to CDS as the intervention of Giethner will confirm. I suspect that the losses would be enough to wipe out the main investment banks again. What will they do then? Another bailout would be a mistake.
The neophyte wonders: the question whether a ‘soft’ restructuring or a ‘soft’ default would trigger CDS payouts on Greek bonds seems to be uncertain. And when uncertainty over contracts swells, the parties have little alternative but to turn to the courts for adjudication. Courts, in turn, are part of sovereign states, rather than part of the financial system. It’s true that they possess considerable autonomy…but its also true, to paraphrase Justice Holmes, that no court can be forced to interpret the law as a ‘suicide pact.’ If American or European courts determine that the contracts as written do not require CDS payout, there is little that the hedge funds and others who bought the CDSs can do on that front, though of course their behavior in other respects will be much changed (and CDS purchases much less attractive).
I have always thought that the players in the financial system, for all their power and savvy and influence, consistently underestimate the importance of the fact that _sovereign_ debt is involved here. The very essence of sovereignty is that sovereigns can change the rules unilaterally and retroactively. To be sure, small semi-sovereigns such as Greece do so at great risk and cost. But when the existential interests of major sovereign states are touched — the US and the Fed, Germany and the Bundesbank, and so forth — all financial players are utterly outmatched. Again, should this reality strike, the costs (to bondholders, to the financial system, to economies) may be substantial. But unless that harm will be obviously greater than the existential threat to sovereigns that the accumulating debt crisis poses, that does not matter. Sovereigns will decide, and they will decide, ultimately, on political rather than economic or fiscal grounds. The long rich history of state bankruptcy in Europe and elsewhere makes this manifest, but bankers don’t study history, or know how to derive a deeper perspective from it.