The Other School of Economics

Is this some capitalist creative destruction? Now that #ISDA says Greece has NOT defaulted, are #CDS finally useless?

How would you feel if your insurance changed the rules to not pay you? This is what ISDA did to Greek CDS holders. And here is how…

The self regulatory body of the Derivatives market, the International Swaps and Derivatives Association (ISDA), ruled on March 1st that the recent restructuring of the Greek debt, which includes a 47% cut in bonds value for private investors, is not significant enough for holders of Credit-Default Swaps (CDS) on Greek bonds to be paid out.

This decision has outraged economic commentators, whose reactions range from “bemused” on the respectable FT to a resounding “WTF?!?” on Barry Ritholz’s Big Picture blog. They are basically asking why anyone would ever want to buy CDS again if they don’t get paid out.

So what does this ISDA decision mean at all?

Rescuing Greece must feel like being the Danaides (here by John Wiliam Waterhouse) (…or Keanu Reeves in Speed, the movie).

Once again, this episode severely exposes the self-serving habits of Financial Market operators and totally questions the added value of those derivatives that they engineer.

First of all, there is the quirky design of these CDS. They were initially created to be insurance policies against a debt default. The trick is that one does not need to own a physical asset to hold a CDS on it. To put it bluntly, holding a CDS is exactly like signing an insurance policy on your neighbour’s house, and you get the money if it burns down! No need to be a financial auditor to have reasonable doubts on this underlying logic: who would be the suspect for an arson?… The financial propaganda may well advertise them as “insurance products”, the moral hazard introduced by unlinking them from the underlying assets really make them pure gambling products.

Secondly, if the initial rules were not flawed enough, banks and hedge funds are also rewriting them as the situation develops. To understand it fully requires to follow the money trail.

The restructuring of the Greek debt is rough to the Greek people, as we reported earlier here at theotherschoolofeconomics.org, and to Greek bond holders of course. The €200bn worth of bonds that those private investors held has been unilaterally reduced to €107bn by the Greek government.

The upside of the deal is that at least, bond holders get to save 53% of value, which is obviously better than losing everything if a default occurs. The downside is that the banks that issued those ‘insurance-like’ Credit-Default Swaps on the Greek bonds are really behaving like insurance companies that would try every trick to avoid paying-out for the damage investors initially sought protection from.

To escape facing their insurers duties vis-a-vis smaller investors, banks and hedge funds are getting help from politicians and regulators.

So this is what it has come to: Germany holds Greece by the balls, while France plays a side kick role in this pantomime.

Indeed, €3.5bn of CDS have been issued on the Greek debt, mostly by German and French banks that would lose a lot if Greece defaults. This is where the Merkozy couple comes into the picture. French President Nicolas Sarkozy, and especially German chancellor Angela Merkel have been ferociously lobbying to protect their national financiers. So EU officials cheered ISDA’s decision that the debt restructuring does not so far constitute a “credit event” triggering a credit default swaps payout.

This is another example making you (rhetorically) wonder if those banks, hedge funds and regulators are still playing according to the “free” market rules…

The Greece-has-not-defaulted statement is available here on the ISDA website, which really is a private club of participants in the Derivatives market looking after standardisation and arbitrage: the very example of the self regulatory ideology broadly implemented in financial markets fuelled with serious conflict of interests.

The Guardian reports here who are the 15 members of ISDA’s EMEA Determinations Committee which stated that Greece has not defaulted. Among them are the most important issuers of CDS on sovereign debts and the Greek debt in particular: Deutsche Bank , JP Morgan Chase, UBS, BNP Paribas and Citigroup. All parties that have too much to lose if Greece technically defaults. This leave little doubt on the nature of ISDA’s unanimous decision.

But this is not the end of it: this saga will keep on giving. Indeed the bias of the ISDA committee might also have a flip side to the flip side. If this decision makes CDS on European bonds very unlikely to be paid out, it is also likely to make those volatile derivatives irrelevant: which serious investor would ever buy them in the future, it they end up being fleeced by banks? And because of the amount of leverage and flexibility they allow versus trading say bonds or loans, CDS have been baked into everything modern finance does. Even regulations like Basel III rely on them (see Deus Ex Macchiato’s blog). This leaves us wonder how far banks can go before they break their shiny toys. Would they want to prove Marx right in that capitalism can destroy itself, they would not do it any other way. Probably a topic for a next post sooner than we think.

{ NKN, Paris – leLaissezFaire, Sydney – 3 March 2012 }