“When is Default not a Default?”

Sydney M. Williams

Thought of the Day

“When is Default not a Default?”

March 6, 2012

In 2009, juggler David Sack kept three balls in the air for twelve hours, five minutes, setting a world record. The European Central Bank (ECB) is trying to achieve a similar feat by keeping profligate states from disorderly default via a process of restructuring debt without calling it default. Greek debt holders, for example, have been asked to accept a deal that equates to a 73% loss. Greek Finance Minister Evangelos Venizelos told private creditors to take the offer, “Because it was the best deal they would get.” They have until Thursday to decide.

Mr. Venizelos, who is running for Prime Minister on the Socialist ticket, assured his European Partners that Greece would stick to its pledges of austerity. “Signatures are signatures,” he said, “Commitments are commitments.” But apparently commitments and signatures do not apply to credit default swap (CDS) contracts. Despite bond holders losing three quarters of the value of their assets, the International Swaps and Derivatives Association (ISDA) has determined that a restructuring Credit Event has not occurred – an enormous benefit to the banks that wrote these contracts, and harmful to those (mostly hedge funds) who had purchased the contracts. And it raises questions: Do credit default swaps on sovereign debt have any value? What role does contract law play in the CDS market?

One of the shortcomings of the Dodd-Frank bill was that it did not clarify the role of credit default swaps. A credit default is a form of insurance for bondholders, protection against an issuer defaulting or in the instance of a credit event that is harmful to the bond holder. That is a valuable capability, allowing issuers to, conceivably, pay lower interest rates, and for investors to better able manage their risk and return. The market is huge. The gross notional value of the CDS market in early 2012 has been estimated at $32 trillion, down from 2007, but up from 2010.

However, a singular (and negative) characteristic of a CDS is that the seller can sell protection that exceeds the value of the underlying bond. That is equivalent to you and all your friends buying insurance on my home in Connecticut. It is no longer insurance; it is a speculative bet and it means that there are several people (you, of course, being the exception) who would have an interest in my house burning to the ground. Dodd-Frank could and should have addressed this, but it did not.

Besides the obvious difficulty Greece will have in conforming to the austerity measures required in the “restructuring”, the whole mess stinks. Bloomberg this morning updated a story that first came to light two years ago about the role played by Goldman Sachs in using derivatives to mask the debt and deficit numbers of Greece in 1999, so that the country would meet the requirements of the Maastricht Treaty, allowing them to join the European Union.

It remains hard for me to believe that a continued avoidance of reality will serve the people of Greece, the European Union, or investors well. Those who object to a default and the re-introduction of the Drachma persistently use the term “disorderly” to scare investors and Greek voters. One cannot help wondering if the European Central Bank, which has an estimated €177 billion exposure to Greek debt against a capital base that is about half that level, has been a factor in urging acceptance of this deal, which penalizes bondholders without providing them the relief a credit default swap would offer, and which subjects the country to years of austerity.

Who is being helped?