Wednesday, November 2, 2011

The Greek CDS tragedy

I am trying to steady my thoughts on the EU saga following the gyrations in stock prices that are still going on. BNP the leading frech bank, gains 30% to lose 15% the next day. This is all scary price action. And amid it all I am not sure I completely understand what is going on yet.

Follow the CDS thread
The one point that really pricked my ears was the bit about asking for a voluntary haircut from bondholders. Since bondholders most likely have CDS this seems quixotic. A bondholder will WANT the default so as to trigger the CDS. Then of course the question is 1/ who sold the CDS 2/ how much of it is naked.

The numbers get big
If there is 350B oustanding greek debt and if we assume a 10 to 1 naked to covered ratio that means that a 350B default event really means 3T of cash settlement. That is a lot of money to be paying out to speculators. Of course that is what the EFSF wants to avoid. So they are trying to nationalize that market, according to what I have read by becoming the sole purveyor of CDS at least in europe.

Naked/non-naked a false dichotomy
This point is rather theoretical but it dawned on me that to an extent CDS are non useful. If the price of protection is less than the yield of the bond, then by buying the bond and the CDS you have a risk free flow. This of course is non-sensical and the price of protection HAS to be the yield (no arbitrage). Therefore a CDS is really a swap, not of the default but of the bond itself. You are out of the equation, at this stage you might as well sell the bond. CDS serve no purpose from that analysis but as a speculative instrument. Arguments that they 'provide' pricing, liquidity and information seem flimsy compared to their risk. They have to be banned, in the naked form. I question their non-naked utility altogether.

The Paulson shadow
Everyone has read 'the greatest trade' where a 250b subprime event was turned into a T level event through CDS (naked) and everyone thought that greece was the next puppy to provide that bonanza. I bet that trade is CROWDED with speculator licking their chops at the prospect of a sovereign default from which they profit.

Where does the chain stop
I have had a hard time tracing that. Some accounts say that it is greek banks that have sold the protection which feels flimsy at best. How can the banking system rescue the country when it is going down. Some say it is the european banks which would explain why the EFSF is destroying the sovereign CDS market. Some say it ends in the united states, specifically at Bank of America amongst others. I find that hard to believe but who knows. Whomever is holding that T level bag (even if distributed) is in big trouble as a T Level event of liquidity will simply crater the markets. This is why the G20 is busy trying to avert "default" by calling for voluntary haircuts.

how does it all end
Very simply put I don't think anyone can sustain a 1-2T liquidity event in the system at the moment. The subprime 250 chain was enough to create the mother of all liquidity crunches that brought about 2008. This time the numbers are bigger and the multiplier on the base even bigger, because everyone wants to be Paulson (the hedge fund). So voiding the CDS market seems like the rational thing to do.

Chain reaction
if this is the case, then the nominal yield on debt will rise to account for real default ex CDS (which it should anyway). So there is only one way out, it is not fiscal integration, it is not default, it is debt monetization. Let the printing presses begin.

3 comments:

Anonymous said...

You have no idea what you are talking about when it comes to CDS.

How can the price of a CDS be the yield of a bond. The CDS is (or was) zero initial cost. There is no funding. The spread must be the yield of the bond minus the risk-free rate. And even that is not exactly true if the bond is trading away from par.

Marcf said...

but that is my point that CDS+Bond == Risk free rate. And since risk free rate == 0, the yield of the bond is the cost of the CDS.

I am not sure what you mean by "CDS was zero initial cost". Perhaps you mean to the issuer in the sense that he needed no collateral (hence your 'in the beginning?). To the buyer there is a cost. I know, I make my living selling puts :)

Sorry but YOU have no idea what you are talking about and when you make such confused points about the basics of an instrument you would do well to not run around like a fool like that.

Marcf said...

oh and of course you do not touch the naked CDS question, because there is nothing to say really.