FT Arrives at Wrong Conclusion on Greek Crisis and CDS
This FT article completely misunderstands what the gross/net numbers mean, and arrives at a totally wrong conclusion.
But this may not truly reflect the size of potential losses for some banks. The gross CDS exposure on Greece is $79bn and some analysts speculate that any one bank may have to pay out as much as $25bn.
Just as critically, say some strategists, a decision against a credit event may call into question the intrinsic value of buying CDS as a hedge against default, bringing the relatively nascent sovereign CDS market to a standstill.
Let’s make up a simplified, stylized example to explain. Let’s say Citi sells $21bn of protection to Deutsche, and buys $20bn of protection from CS.
Deutsche then sells $20bn of protection to CS.
The gross CDS outstanding is 21+20+20 = $61 billion; each deal is counted once.
But Citi only has $1bn of net exposure (net seller, it will have to pay if Greece defaults), and since for every buyer there’s a seller, there must be $1bn somewhere else… indeed, Deutsche in this case is a net buyer of $1bn of protection. CS has bought and sold equal amounts and is flat.
DTCC would thus report $1bn of net exposure and $61bn gross exposure in the Trade Information Warehouse (table 6).
What happens if there is a default? Yes, Citi has to pay $21bn to Deutsche, but it receives $20bn from CS. These will be settled on the same date so there is no liquidity risk; the $25bn figure the reporter has is irrelevant.
The big problem here is *counterparty risk*. If one of the three banks fails like Lehman, all its deals are closed out instantly as per ISDA docs; for the remaining banks the net is unchanged but suddenly small net exposures become huge. And because the world is probably going pear shaped, the buyer of protection is happy to stay unhedged, while the seller must try to hedge out his position at a terrible loss. A related issue is that Greek banks may have CDS (and other derivatives), if they go belly up, impose a bank holiday or capital controls, that would have a similar ripple effect as their counterparties realize their risk book is blowing up.
The article is also wrong on questioning the “value” of CDS following a restructuring. Ford, Harrah’s and others restructured debt without triggering default; CDS were trading as high as 10,000bps for both, reflecting low expected recovery values. The CDS were not triggered even though in some cases par amounts were reduced significantly, along with maturity extensions – all the things RGE has argues Greece will need to do. Of course the market will evolve, but the corporate CDS market is doing just fine, last time I checked.
Source: Financial Times (Subscription req.) Greek Crisis Puts Future of CDS in Doubt by David Oakley
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