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The CDS devil's in the details

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Joel Thorson
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The world will know by sometime tomorrow (Thursday 2/29) whether the Greek debt deal constitutes a "credit event" triggering credit default swaps (CDS) payouts.

It's a very technical topic.  Why should anyone in the U.S. care, when Main Street and Wall Street are enjoying a little bounce?

A clearinghouse which tracks CDS trafficking seeks to reassure us that the net amount of CDS written against a Greek default is "only" $3.2 billion, arguing on that basis that the world can easily absorb the default.  Not so fast.  The full notional amount of payouts due would be almost $70 billion.  The $3.2 billion net, in other words, is what you get by summing up all the winnings and losings -- and deliberately misses the point.

Obviously, some of the gamblers will win and others will lose.  Among the losers, some will lose bigger than others, maybe very big.

One way of speculating on a huge profit over the last couple years would have been to buy up tons of CDS paper, stocking up on the original sellers' positions  -- taking on the "insurance company" role, in other words -- to skim the lucrative premium payments while putting yourself on the hook for an enormous payout.  Perhaps much larger than you can possibly make good on.  The income stream from the premiums might even be enough to offset the carrying cost of borrowing money to finance those positions!  The big score comes in the form of a huge capital gain on your CDS paper assets if the restructuring deal succeeds without triggering payouts.  And the score is even bigger depending on how much leverage you used.  If you're a big risk-taker, your capital gain might not have cost you a dime out of pocket, in which case the payoff at the end is free money.

Anyone playing this game will be grievously wounded if things go the other way.  Who if anyone has been betting the farm ?  Back in 2007, giants like Lehman, IndyMac and AIG were making tons of profits doing exactly that until the very end, and nobody knew about it -- or if someone did, they weren't saying, because they were raking in huge bonuses taking reckless risks with Other People's Money.

Five years down the road, we still don't know who's on the hook, because nothing has been done in the meantime to make CDS trading more transparent .  Real insurance companies are regulated to prevent this kind of risk-taking.  But the swaps market today remains a completely unregulated back-alley crapshoot.

As Warren Buffett said, you can't tell who's been swimming naked until the tide goes out.

Private bondholders must say by noon PST tomorrow (Thursday) whether they're participating in the Greek debt deal.  Ater that the ISDA (the international arbiter of swaps payouts) will decide whether the restructuring constitutes a "credit event."  That's when we'll learn who's been swimming naked.  If anyone the size of Lehman, IndyMac or AIG is caught with their trunks down, there could be CDS explosions, leading to sudden bankruptcies, followed by more CDS explosions and more bankruptcies.  Let's hope not.  Stay tuned...

Here are links to two articles shedding light on this obscure, complex, and frighteningly consequential topic as the story plays out.  Note that even the otherwise excellent Reuters piece gets the terminology wrong, labeling the $3.2 billion number (the net of wins and losses) as the "notional" sum of swaps payouts, which it is not.  The actual notional amount is $69.9 billion:

From the Wall Street Journal:  "The Mechanics Of The Big Greek Debt Swap"

From Reuters:  "ISDA to discuss whether Greek debt swap a 'credit event'"

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Joel Thorson is a a software engineer who lives in Portland, OR. Before tackling software he was an English major, taxi driver and newspaper journalist, moonlighted as a bouncer at a Moebius strip club, apprenticed as a quantum mechanic, and (more...)

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