Saturday, January 28, 2012

The Greek debt deal and backroom...

The news, especially apparently CNBC, is populated with tons prognostication and rhetoric about a Greek debt deal. I would like to make it clear that these prognostications and marketing attempts are simply that. They are hot air. Lets take a closer look at what is going on and then come to a conclusion that actually has relevance.

In recent history, bureaucrats have been trying to get various exceptions or adjustments into supposedly free markets for debt insurance - called CDS - Credit Default Swaps. The concept of a CDS is simple: in the event that counter party is unable to repay within terms CDS protection will compensate the buyer commensurate with the amount defaulted. Lets take a closer look.
A credit default swap (CDS) is an agreement that the seller of the CDS will compensate the buyer in the event of a loan default. The buyer of the CDS makes a series of payments (the CDS "fee" or "spread") to the seller and, in exchange, receives a payoff if the loan defaults. 
In the event of default the buyer of the CDS receives compensation (usually the face value of the loan), and the seller of the CDS takes possession of the defaulted loan.  
Anyone can purchase a CDS, even buyers who do not hold the loan instrument and who have no direct insurable interest in the loan (these are called "naked" CDSs). If there are more CDSs contracts outstanding than bonds in existence, a protocol exists to hold a credit event auction; the payment received is usually substantially less than the face value of the loan. 
Most CDSs are documented using standard forms promulgated by the International Swaps and Derivatives Association (ISDA).
CDS’s are not traded on an exchange and there is still no required reporting of transactions even after the AIG debacle. Credit default swaps and other derivatives are unusual--and potentially dangerous--in that they combine priority in bankruptcy with a lack of transparency
Now lets look at what has been going on with the bureaucrats:
Oct 27, 2011 2:03 PM ET
The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.
As part of today’s accord aimed at resolving the euro region’s sovereign debt crisis, politicians and central bankers said they “inviteGreece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities. If the International Swaps & Derivatives Association agrees the exchange isn’t compulsory, credit-default swaps tied to the nation’s debt shouldn’t pay out. 
“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”
So the pressure right now with regard to Greece is not a negotiation. It is not a haircut and it is not a restructuring of the existing bonds. It is in a desperate phase and its goal is to save the leveraged financial system. The consequences of the a credit event or a credit restructuring in Greece are not to be misunderestimated (thank you George Bush). They are DIRE.

If we were looking at a situation as it is presented with rose colored glasses via the main stream media, then we would ascertain that big countries like France, Germany and the US and a few select institutions control and own almost all the bonds issued by Greece and are thus able to agree to new terms or securities fairly easily. This, however, is a very convenient presentation of situation. However, reality is nothing like that. These bonds are held by Pensions, Hedge funds, Institutions, Central Banks, Individuals and other Sovereigns. 

The managers of the portfolios of many of these investors have bought CDS insurance for their portfolios. Many of them may have a PPM or offering memorandum that discloses their strategy very precisely…this means that many managers have a legally enforcable mandate to trade debt with CDS protection as hedges. 

Imagine if you will, that you are a client of one such a manager and he may have thousands of clients. This manager has a fairly simple scenario. Accept a haircut and restructing of some of his assets that may fall out of his PPM and by the way take 80% losses on principle…not including CDS premiums. The manager can call every one of his clients and get agreement to make an exception for these instruments or more than likely he can call you and say: 

  • PM: "Mr. Smith, Greece is offering us 20% of principle on our bonds, the CDS insurance that I bought is worthless and I think we should take the haircut.” 
I think that it is very easy to understand that your response will be very simple: 
  • You: "Why were you investing in crap bonds and what the hell were you doing buying worthless insurance with my money. Are you trying to tell me that we invested capital and then another 25% of principle on insurance premiums and we are only going to get back 20% on capital and with some of that coming years from now?”
  • PM: “Yes”
  • You: “Are you telling me that we have insurance that will pay me back the 80% of princinple that is being defaulted but you want to elect to NOT use that? or is the insurance a fraud?”
  • PM: "The insurance is good but officials are trying to get this not to be called a credit event so I am trying to comply with their wishes by simply agreeing to a haircut and tossing the insurnace and the permiums all together. I think its simpler that way, even though its outside our PPM.”
  • You: “How many other bonds have similar arrangements and risks regarding their insurance? I thought you told me that we were running a low risk hedged portfolio of sovereign debt…what have you been doing buying insurance that you don’t indend to actually use to get MY MONEY BACK?”
  • PM: “A lot of our bond portfolio is hedged with CDS but I think those are good…but you never know the outcomes of situations like this…right now I am just concentrating on trying to get the most principle repayed as fast as possible and not get this a resolution drawn out for years”
  • You: “Look is the insurance GOOD or NOT GOOD? if its good I want you to collect and get MY money back. After which I will be sending you my redemption request. What kind of operation are you running and what kind of crazy deals are you willing to make with MY MONEY. I just can’t believe you would buy insurance for 25% of the face value of the note and then elect not to use it and take 20% of face value back instead…
  • PM: “Look Mr Smith, please calm down, I am just trying to get an acceptable resolution for us all…”
  • You: “You are not succeeding...Hang on while I call my lawyer.”
So, what is clear is that IF there are  few large investors that comprise the biggest holders of debt issued by Greece for example they are accountable to thousands of other clients and will have to negotiate indemnity with all of them in order to agree to a deal that is a clear conflict of interest. One does not buy insurance and then simply ignore that one has it. If you are working for someone else and chose not to file a claim simply because you are being cooeerced to - you can count on getting nailed to the wall. In the case of our imaginary Portfolio Manage above…he stand much better chances with just letting the bonds default, attempting to collect the insurance and then when or if the insurance does not pay demonstrating to his clients that he is not culpable. He may have bought bad bonds and bad insurance but he followed his PPM to the letter and acted ethically at all times. The problem is the other guys who he can now sue…every last one of them…Greece, ECB, the CDS counter party and anyone else he can find. In this case, he can also simply wind down his fund and open a new one. In the alternate case, he will get sued by his clients but with no escape hatch and no one else to blame. Which would you chose if you were a PM? I would choose to follow my PPM and live with the consequences. I would find it far more productive to tell a client about a disaster than to try to force feed them an even bigger one and get all the accompanying liability and culpability.

A simple way to think of this is that you borrow money from a friend, say $100,000. You run into a financial difficulty and let your friend know that you need to restructure or default. In that case, you are dealing with just one person and its fairly easy for both of you to determine the implications. However, if your friend who lent you the money, used money from 20 other sources at $5,000 each to fund your loan…then this is no longer just between you and him…he has responsibilities to his partners or clients. Additionally, if he committed to them that he had purchased some sort of default protection, these participants will not be interested in hearing about how much he likes you or wants to avoid confrontation or the results of him getting kicked out the apartment he rents from you when you can not longer afford it because you are in default and he is required to collect. His partners will want to collect from you and the insurance…any interference or alternate scenario painted by your friend (in the PM) in this case, will result in much more conflict and risk for him than if he just attempts to collect and deals with the consequences. His 20 participants can accept if the insurance does not pay because the counter party risk blows up and that is not expected…however, the reality is they will ALL look at the insurance as a high probability asset and the restructuring as a much lower one. 
“It has always been understood that the restructuring definition cannot catch all possible events,” according to the statement. “If a creditor is hedging using CDS, and declines to participate in a voluntary restructuring, then the creditor would still hold its original debt claim and its CDS hedge.”
The implications of what is going on this weekend are huge…there is NO possibility that a reasonable solution can be negotiated if there are portfolios of individuals rather than taxpayers involved. The consequences are too great for the PM’s and the participants will want their protection that they expected and paid for to be executed and settled. The results of that however, will be total economic upheaval in Europe and will spread to the US. The CDS and derivatives overhang is a huge issue and will not go away anytime soon. Over leveraged balance sheets are supported entirely by assumptions made based on their derivatives hedges and the fact that they can and will be executed. What we are seeing is direct interference in the transactability of these contracts and that is notwithstanding the fact that the financial system does not have enough money to transact on them.

There is just no way to bureaucratically interfere with every deal or to entice people into participating in a far less attractive one. Certainly, it would be that much more challenging to get a deal even in discussion if risk markets were tanking…so, the January risk rally has been rather helpful, to say the least.

There will be no miracle deal…even if there is an announcement it will effctively be a default and WILL include a CDS trigger...if there is no deal and no possibility of a reprieve then Greece can not get its financing from ECB. Without that financing they can not make their next payments and moreover, the CDS market will execute, spread and prove just who is not wearing underwear in this 2012 version of our 2008 financial crisis.

The CDS and derivatives issue is absolutely stupendous. If Greece CDS will be forced to execute then it will be the same for Portugal, Belgium, Spain, Italy and a host of other countries not to mention institutions…the mad rush for cash and liquidity will happen much faster than people think and will run into a brick wall as people realize that the is not enough money in the system to settle the transactions. Did you buy your dollars yet?
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