Greek CDS Exposure: Proving the ISDA and Bloomberg Wrong

According to numerous news reports, the net exposure arising as a result of Friday’s decision to declare the activation of Greek CACs a credit-default event amounts to approximately $3.16 billion (assuming that the bonds achieve no value at the ISDA auction on March 19).

Where is the data coming from?

On the same day that the ruling announcement was made, the ISDA issued a FAQ document relating to the Greek Sovereign CDS credit event. Both these documents can be downloaded at http://www2.isda.org/greek-sovereign-cds/. This document makes reference to the $3.16 billion net notional as disclosed by the DTCC (The Depository Trust and Clearing Corporation). In fact, the publication erroneously links to Table 5 of the DTCC data – the actual figure is found in Table 6. Link: http://www.dtcc.com/products/derivserv/data_table_i.php?tbid=6. Table 6 discloses the Top 1000 Reference entities for the swap arrangements (ie. the issuers of the instruments being covered by the credit default swaps). Under the heading “Hellenic Republic”, the sovereign debt gross notional is disclosed as $68,901,331,331; and the net notional is disclosed as $3,162,579,257.

What is the problem that people are having/should be having?

The problem appears to be twofold:

1. The preliminary list of bonds submitted to the ISDA for restructuring credit event consideration included issuers other than the Hellenic Republic. 
2. Is the sovereign debt exposure figure presented by the DTCC a fair reflection of economic reality? 

Problem 1: The Other Issuers on the Preliminary List

From my reading of the ISDA public announcements, the problem is as follows:

1. The preliminary list of bonds submitted for review (released by the ISDA on March 7 – this can also be downloaded from the link identified above) includes issuers other than the Hellenic Republic. No basis for the inclusion is given, nor is it required. The list is not final – rather, these are the bonds that the public has asked the ISDA to consider. 
2. It is suggested that the reason for inclusion is on the basis that many of these issues have guarantees issued by the Hellenic Republic. Given that the trigger event was the activation of CACs, one could infer that the default will only extend to those bond issues where CACs have been retroactively imposed (ie. only Sovereign Debt). 
3. The ISDA has not identified the bond issues to be affected by the default announcement: the wording is specific to the occurrence of a Restructuring Credit Event. 
4. According to the announcement, the EMEA Determinations Committee is currently in the process of reviewing the preliminary list of submitted bonds. 
5. Therefore, the magnitude of the default event will only be set after the EMEA DC formally identifies the bonds affected. 

Can impact of the other issuers be quantified?

The issuers identified in the preliminary list of submitted bonds are:

1. The Hellenic Republic 
2. Athens Urban Transportation Organisation (OASA) 
3. Attica Bank S.A. 
4. EFG Eurobank Ergasias S.A. 
5. Hellenic Railways (OSE – Organismos Sidirodromon Ellados) 
6. National Bank of Greece S.A. 
7. New Economy Development Fund S.A. (Taneo) 
8. Proton Bank S.A. 
9. Aeolos S.A. 
10. Ariadne S.A. 
11. Agricultural Bank of Greece S.A. 
12. Alpha Bank AE 
13. Piraeus Bank S.A. 

According to Mark J. Grant in his article “The Eight Hundred Pound Greek Gorilla Enters The Room” (link: http://www.zerohedge.com/news/eight-hundred-pound-greek-gorilla-enters-room) – these other bond issues are going to increase the CDS impact number up to $79 billion.

I’m not sure where that number comes from, but I’m going to assume (for this section) that the DTCC figures are correct. If they are, then with the exception of the Hellenic Republic, none of the above issuers feature in the Table 6 Top 1000 reference entities. The smallest of the Top 1000 (by net notional exposure) is Nextel Communications, with a Gross Notional of $1,649,302,354 and a Net Notional of $105,475,330. By inference, therefore, the maximum additional net notional exposure to be added by the other 12 entities identified is an extra $1.3 billion ($105 million by 12).

However, as I have previously stated, this is unlikely to be a real consideration as the triggering event is the activation of the Collective Action Clauses – an event which should have no direct default impact on government guarantees given to state-owned entity and domestic bank issues.

Problem 2: Is the DTCC’s calculation correct?
Renowned investor Jim Sinclair (JS) in an interview with King World News suggests that the real question to be asked should be: is the amount calculated by the DTCC correct? He says that the DTCC amounts calculated are only in respect of transactions taking place within the US (ie. they exclude foreign bank transactions, as well as transactions undertaken by the foreign subsidiaries of US banks). If that were the case, then we would have to look for the real information in the data presented by the Bank of International Settlements (BIS).

The latest data available from the BIS takes us up to June 2011. According to Jim Sinclair, the total CDS market approximates $37 trillion, of which over 50% must relate to Greek debt. The first figure is supposedly drawn from BIS statistics; the second is based on his 50 years of market experience.

Well, the first figure is factually incorrect (or perhaps chronologically incorrect – it’s always possible that the number referred to a different point in time). At the end of June 2011, the total outstanding CDS market, according to BIS, was $32.4 trillion (net exposure).

As regards the second, the BIS gives a breakdown of the CDS market based on reference entity sector. Of the $32.4 trillion, only $2.9 trillion actually relates to Sovereign Debt. The only other potential impact is in the sector of the CDS market held over CDO instruments, which may or may not include Greek sovereign debt issuances in default. This sector of the market constitutes a net notional $0.9 trillion. So in total: a potential exposure of $3.8 trillion.

Obviously, this is significantly larger than the $3.16 billion being used by the ISDA (over 1000 times larger). And Jim Sinclair does make a good point: the DTCC tagline for its data is that “this section provides comprehensive reports on the vast majority of CDS contracts registered in the Warehouse’s global repository” (link: http://www.dtcc.com/products/derivserv/data/index.php). Obviously, CDS contracts that are not registered with the DTCC would not be included in this data. And it certainly sounds like the DTCC captures only the US portion of the market.

As a reasonability check, compare the total of the Table 6 Top 1000 reference entities to that of the total CDS market according to the BIS figures. The total net exposure of the DTCC Top 1000 is only $1.1 trillion, compared to the $32.4 trillion of the BIS. If we say that the DTCC figures approximate the BIS figures, the balance of $31.3 trillion must then be made in reference to other issuers. Given that the Top 1000 include governments and all major corporate and parastatal bond issuers – this implies that the majority of the CDS market has been taken out against small issuers! Highly unlikely.

As a final check, one should consider what the figure of $3.16billion is implying about the global debt market. I have used Table 15B of the BIS quarterly statistics (link: http://www.bis.org/publ/qtrpdf/r_qa1203.pdf), which breaks down the Total International Bonds and Notes by nationality of issuer. Whilst this statistic uses total international bonds and notes outstanding rather than just sovereign debt, or a combination of both international and domestic debt: the point is to illustrate the proportion of the international debt market that is made up by Greek debt. 

Total International Bonds and Notes Outstanding (in US billions)
Greece	397.40
The World	27 819.70
Proportion represented by Greece	1.43%
Total CDS Net Notional Exposure (in US Billions)
CDS Net Notional Exposure (DTCC)	3.16
World Net Notional Exposure (Sovereign Debt) - from BIS	2 907.80
Proportion represented by Greece	0.11%

If we just assume that all investors were blind and equally distributed their CDS investments between countries, we would expect Greece’s net notional exposure to approximate its portion of the debt market. Even more so, we would have expected investors to flock to CDS instruments over Greek sovereign debt, given the economic fundamentals of Greece’s position (ie. you’re much more likely to buy insurance when your house is made of untreated wood and situated next to a blacksmith, than if your house is made of stone). Instead, the ISDA (and Bloomberg) would have us believe the opposite, that investors underweighted their CDS exposure to Greek sovereign debt.

Is there a reasonable explanation for underweighting?

I think that there is an argument to be made here. After all, why has a Greek default been delayed for so long? A year ago (even 6 months ago), the Euro leaders were all against causing a credit-restructuring event for fear of triggering CDS instruments and causing contagion. And now suddenly, everyone is keen for a default. Including Greece, who elected to action the CACs to top up the extra 14% of the debt – where they could have just restructured the 86% voluntary portion and gotten away with it. So the question is: why now?

I think that the delay has accomplished two things:

1. If I were speculating on Greek sovereign debt defaults three or four years ago (back when CDS instruments were cheap), I would have purchased CDS instruments over the debts issues that were falling due in the short-term – as these would have been much more likely to default (as their repayments would have fallen due sooner). By stretching out the time to default, some of the original CDS instruments will have lapsed, as Greece has managed to meet its debt obligations up and until this point; albeit with the assistance of the first bailout. And in the interim, as the market realised the Greek crisis, the spreads on Greek Sovereign CDS widened making it almost prohibitively expensive (and therefore unprofitable) to purchase more CDS instruments. Greece and the Eurozone may have faked it until they made it. 
2. The delay also gave the major banks the chance to recapitalise in anticipation of a default, and to rebalance their positions.

So perhaps the ratios sound about right.

Conclusion
Either way, the $3.16 billion figure is wrong. If anything, it is only the lower end of the range. What we can say is that there is definitely $3.16 billion of net exposure – but that it seems to only represent the US exposure. The rest of the world’s net exposure is floating somewhere in the $2.9 trillion of the BIS statistics.

The Subprime Mortgage Crisis

Alright, before I begin, I'd like to make the following observations:

1. Some of the concepts/instruments I am going to mention have been explained more fully in a number of previous posts:
• Mortgages (see here)
• Mortgage-Backed Securities (MBS) (see here)
• Collateralised Debt Obligations (CDO) (see here)
• Ratings Agencies (see here)
2. The content is based on a lecture that I attended on the Sub-Prime Crisis during my postgrad. Most of it is factually supported by papers and books I've since read on the topic. However, there is obviously some academic opinion being asserted here: this is not the only view of the underlying causes for the crisis. 

And here we go:

The important thing to realise about financial crises is that they generally begin with a really good idea. 

The Asian Currency crisis of the late 1990s, for example, began with a number of small loans to companies in emerging markets. These offered high rates of interest (to compensate for the risk of emerging markets) under mostly fixed exchange rate regimes (tied to the US dollar); and these economies had been showing high rates of economic growth - very attractive. When Wall Street saw how successful those first few deals were, it got greedy and started to pump the South Asian economies with loaned money. Too much money for these economies to sustain: leading to asset pricing bubbles (as the Asians looked for assets to buy with all this money). The Southern Asian economies were now primed for crisis - huge external debt ratios based on artificially high asset prices under fixed exchange rates. 

Then typically, some exogenous (external) factor comes into play. As Alan Greenspan started to raise interest rates in the late 1990s, US investments suddenly began to look more attractive. As more investors started to remove their money from Asia and bring it back to the US, the asset pricing bubbles burst. Borrowers began to default on their loans as the loan values were so much greater than the value of the underlying asset. Lenders panicked and started withdrawing their money, putting the fixed exchange rate regimes under intense pressure. Eventually, the Thai government was forced to float the baht, which depreciated instantly, losing almost half its value. This sparked contagion as all emerging economies were lumped in the same boat and had their financing pulled. 

Great idea to begin with, followed by much greed, a sudden trigger, and a subsequent flood of fear (contagion). 

So what was the great idea behind the Subprime Mortgage Crisis?

Well - no prizes for guessing that it was the "Subprime Mortgage". Some points:

1. A subprime mortgage has nothing to do with the prime rate of interest, contrary to almost every South African's personal opinion. These were not mortgages offered at interest rates below prime.
2. The adjective "subprime" refers to the quality of the mortgage-holder. 

And what do we mean by that? Well - a prime mortgage-holder, for example, would be a candidate with a salaried position, getting monthly pay-checks with a verifiable credit history. 

But this leaves out a portion of the population who may easily be earning as much (if not more) than a salaried individual, but without the payslip documentation to support it. A waitress, for example, may earn a lot more in tips than your average till operator. Or strippers. Strippers can earn very well - but sadly, no paycheck to support that.

Solution: a subprime mortgage. The financial services industry acknowledged that this part of the population could afford to pay back a mortgage, even if they couldn't always support that with documentation. Therefore, they starting awarding them mortgages that charge slightly higher rates of interest - a "subprime mortgage" - to compensate for the additional risk of unsecured income.

And these first subprime mortgages were very successful. In fact, the top tier of subprime mortgage-holders were probably more likely to repay their mortgages than the lower ranks of prime-mortgage holders. Furthermore, because they were "subprime" they were earning higher rates of interest. So the subprime MBS were a giant hit: particularly after the ratings agencies put on their Midas-touch gloves and bestowed triple-As like confetti.

And, at this point, let me just say that these weren't entirely unjustified. You see - the MBS makes sense in a lot of ways. It's literally "as safe as houses". In moderation - assuming that houses have real value.

But then the Wall Street investors got very excited. Imagine the world's money supply raising its nose and howling at the moon as it diverts its behemoth bulk in this new subprime direction. The Investment Banks went into mad scramble to satisfy this insatiable need for more subprime MBSs. And how was this possible?

Dirty Piece of the Puzzle Number 1: The repeal of the Glass-Steagall Act


After the Great Depression, the Glass-Steagall Act was enacted at the instigation of FDR. Mr Roosevelt was not a fan of the banks, or of big business in general - and he put in place some serious legislation to regulate them. The Act separated the activities of Commercial and Investment Banks - these could no longer be held by the same holding company. Commercial Banks, which are in the business of deposits and loans (including mortgages), are grantors of credit. Investment Banks, which are in the business of creating and selling securities, are users of credit. By legislating their separation, the Commercial Banks' solvency was kept ring-fenced from the much riskier activities of Investment Banks.

From the late 1980s (ironically, or perhaps not: around the same time that the first investment bank-originated MBS instruments were created), the banks began to push for the repealing of the Glass-Steagall Act. On November 12, 1999, Bill Clinton signed the Gramm-Leach-Bliley Act into law. And with that signature, the Glass-Steagall Act was effectively repealed.

Now that all sounds fairly ominous and dramatic (it's what I was aiming for), but what does it really mean. And I get to come back to my favourite topic: incentives.

Dirty Piece of the Puzzle Number 2: Banking Incentives

If you look at an Investment Bank, how does it make its money? One major source of income is the packaging and sale of securities. It buys the underlying assets at a discount, creates the security, and then sells it to investors - charging fees every step of the way. And how does it make more money? Well - it could try and make new products - but that involves convincing investors that they should buy them. By far the easiest way to increase revenue is to sell more of the bestsellers: the products that the market knows and wants.

On the other side of Glass-Steagal, how do Commercial Banks make money? Well, they collect interest on loans and mortgages, which should always be higher than the interest they pay on deposits. All things being equal, a Commercial Bank is really interested in loans and mortgages of solid credit quality.

And in a pre-1999 America, Investment Banks would have been originating their securities using asset books bought from the Commercial Banks. So the limit on the supply of loans and mortgages to repackage and sell as securities was set, to a large extent, by the conservative goals of the Commercial Banks.

Post-1999, the Investment and Commercial Banks could now fall under one umbrella: one grand financial institution with Investment Banking and Commercial Banking arms.

The question then becomes: what are the incentives of the newly-formed megabank? Well, the objective is still to make more money. And naturally, this comes back to the Investment Banking arm - because that's where the real money is. The bulk of the money in this world is in the hands of institutions, not individuals. Investment Banks are there precisely to cater for the investing activities of institutions.

And if the investors want Mortgage-Backed Securities; well then, there must be mortgages to repackage. So the Investment Banking guy calls the guy down at the Commercial Banking side and tells him to originate another mortgage already. And then the management team gets down to strategise and synergise - and they say something like the following:

1. "Subprime Mortgage-Backed Securities are selling like hot cakes at the mo".
2. "We should capitalise on this"
3. "Commercial banking guy - what can we do to increase our subprime-mortgage asset base?"
4. "Well Mr CEO, we can probably pull something together. I'll just tell the guys that this year's bonus is gonna be based on how many mortgages they pull in."
5. "Excellent, Commercial Banking guy. I like your style. Group Risk Guy - do you see any problems with this"
6. "Yes, Mr CEO, I'm glad you asked. The problem is that if we start doing that, we'll get a mortgage book of Jerry Springer contestants. Not the most reliable guys to give mortgages to."
7. "Group Risk guy, you're fired. Deputy Group Risk guy - congratulations on your promotion. Do you see any problems with this?"
8. "Well, Mr CEO. I hardly think that the mortgage-holder matters. The mortgages are backed by houses. If the Jerry Springer contestants default, we'll just sell the properties and lend to new people. And everyone knows that property prices never go down"
9. "Excellent, new Group Risk guy. I like your style. Let's make money, gentlemen. This year's profits are going into the Bush campaign. That guy is dumb as soap. We need him."

And with that, the mortgage-lenders went into overdrive. The market was flooded with cheap and readily available mortgages - and credit-checks were not recommended for the wheeling-dealing bankers with all eyes focused on the year-end bonus prize. 

Even then, surely the Jerry Springer folk would have been stopped in their gleeful tracks by the growing monthly mortgage burden? Enter:

Dirty Piece of the Puzzle Number 3: The Teaser Mortgage

In 1982, the Alternative Mortgage Transaction Parity Act was passed. This permitted the issuing of Adjustable-Rate Mortgages, Balloon Payment Mortgages, and Interest Only Mortgages.

• Adjustable-Rate Mortgages permitted banks to issue mortgages with fixed rates of interest initially, that would then turn into floating rate mortgages after a number of years. 
• Balloon Payment Mortgages are not fully "amortised" over the period of the mortgage - there is therefore an amount outstanding when the mortgage period ends, which must then be paid as a balloon payment. 
• Interest Only Mortgages are exactly what the name implies: only the interest accruing on the principal is paid every month - at the end of the period, the mortgage-holder will usually enter a more regular mortgage agreement where monthly repayments of principal will also take place.

In my mind, these mortgage varieties were put in place to attract young home-owners whose earning potential is set to increase a few years after the mortgage is first taken out. That's the positive interpretation. The other side of the coin (pun intended) is that it opens the mortgage market up for banks - because post the AMTPA, they had access to people who may not have otherwise bought homes. 

And like all good ideas, when the right incentives are put in place, they can be twisted into gains. All that it requires is small print, technical jargon, and a financially motivated sales force to con the financially gullible into commitments that they will never be able to honour. I'm not necessarily saying that this is what actually happened all the time - but when you hear about strippers owning 5 homes, you begin to see how the logical process to get to that point is greed - just not that of the stripper.

Dirty Piece of the Puzzle Number 4: The CDO

As described in my CDO post (see here), while the banks were quite capable of selling off the investment grade securities of the MBS issue, it was not always so easy to sell the junk securities.

At first, these unsold securities were combined with many other ABS securities and repackaged as Collateralised Debt Obligations. But as time went on, and more subprime MBSs were issued, the subprime MBSs began to occupy larger and larger portions of the CDO pools. At the same time, there were obviously more CDOs being issued - which meant that larger portions of the CDO pools were being taken up by riskier tranches of previous CDO issues.

In metaphorical terms, this is quite similar to a game of jenga. As the game went on, heavier pieces were being put into play (the newer subprime MBSs), and other pieces lower down were being constantly moved to the top (the CDOs), creating ever more elaborate (and more precarious) towers.

Dirty Piece of the Puzzle Number 5: The Ratings Agencies

So we now have growing numbers of subprime mortgages being repackaged and sold as MBSs; as well as a growing number of CDOs composed of subprime MBSs and other CDOs. And to be clear, the number of sub-prime mortgage loans being originated meant that the banks had to be scraping lower and lower down the barrel of the American people, as was demonstrated by the growing number of delinquencies in the mortgage pools. But even on a conceptual level, you can see how giving out more and more loans to the same population of people must mean that you are taking on the risk of the sectors of the population that have never previously been able to afford mortgages. 

But while all this was happening, the ratings agencies were continuing to give out the same ratings as they had to the original deals. A glorious haze of AAA ratings!

Many authors suggest that the people in the ratings agencies actually had no idea what was going on with these financial instruments. The securities had become so complex and theoretical that the underpaid and otherwise-incentivised employees at the Ratings Agencies just began rating these issues in a perfunctory fashion - all the while safe in the knowledge that the underlying assets were houses, and that the bankers could never be so stupid as to screw themselves.


It always amazes me when we assume that the desire for instant gratification is outweighed by the desire for delayed gratification. In the end, I reckon that will be the downfall of Capitalism: it has no real mechanism to control the superiority of the short-term over the long term.


Dirty Piece of the Puzzle Number 6: Special Purpose Entities


As the investment banks were selling off all of these products, they occasionally needed to bridge the sale. That is: not all of the securities would necessarily be sold at the date of issue. Also, investment bankers occasionally like to act as "market-makers" - whereby they add to the demand of the market by buying their own products. This keeps the bid prices high, as the banks are effectively bidding for their own instruments.

This is usually done by the establishment of a Special Purpose Entity (or Special Purpose Vehicle - SPV), which will purchase securities on behalf of the bank. Effectively, however, the liability continues to rest with the banks themselves.

Dirty Piece of the Puzzle Number 7: Credit-Default Swaps

As discussed in the "Real Issue with the Greek Debt crisis" post (click here), the banks had started orchestrating credit-default swap arrangements (CDSs) as a type of third party insurance for investors taking the other side of the bet (that the MBS and CDO instruments would fail). The counter-parties for the CDSs were insurance companies like AIG, which would in turn spread their insurance risk by reinsuring their exposures with other insurance companies.

As there was no ownership requirement, investors could take out CDSs on bond issues that they did not own, and there was no real limit on the number of CDSs that could be taken out on a single bond issue. Why is this so dangerous?

Well, a CDS would allow an investor to take out insurance on the full value of the bond issue, in return for a monthly premium. In the event of default, the insurer would pay out full value of the bond issue to the counter-party. Ten CDS on the same bond issue would result in the insurer paying out ten times the value. Literally, almost no limit other than the insurer's willingness to write the policies. And apparently, they were quite willing to just write them.

How did the puzzle come together?


So we have all these underlying problems lying in wait, and all it needed was a trigger.

Now this is where the debate really comes into play. Did the banks just suddenly wake up and realise that it had all gone horribly wrong? It seems unlikely that they got there on their own - most doomsayers were dismissed (literally - as in "fired"). When the banks did eventually realise that it was all going awry, something had already sparked it off.

The data on home-loan mortgage origination shows that originations peaked in around 2003, but stayed high for a few years after that. Assuming that a large number of these MBSs were backed by teaser (adjustable-rate) mortgages, you could argue that the initial fixed rate periods were ending in late 2006 and early 2007. At this point, monthly instalments shot up, and the Jerry Springer show started to turn delinquent on the banks, sparking off a series of foreclosures. As the foreclosures started, the US housing market was suddenly burdened with a series of distressed sales, causing housing prices to fall. As the housing prices fell, so more of the Jerry Springer show began to realise that they were paying off principals that were potentially higher than the value of their properties. So they got more delinquent. Which caused more distressed sales. Which caused further falls in housing prices. Which caused more delinquencies.

And then the Jerry Springer show realised that the banks were under so much pressure from all these foreclosures that they weren't able to get round to them fast enough. And the banks would rather that the houses had a tenant that be left derelict. Which sounds a lot like free rent.

Bonus.

As this cycle happened, so the Investment Banks came under liquidity pressure. All these MBSs and CDOs are floating around with cash-flow requirements. Also, as some of the banks had bought some of their own MBS and CDO instruments and housed them in SPVs - so they were fully exposed to the growing delinquencies in the housing market.

At the same time, the government-sponsored enterprises (the Fannie Mae and the Freddie Mac), which were the first issuers of MBS instruments back in the 1970s, had guaranteed the cash-flows of their MBS issues. And as their guarantees started to be called in, they needed to be supported by the Fed.

And the contagion started.

The housing market crashed. The subprime MBS market crashed. The CDO market crashed. The banks were exposed and needed to be bailed out. Banks that had gotten out earlier bought out banks that were distressed. Goldman Sachs won (that seems to be my general impression).

Then the CDS instruments started to be cashed in. So the insurance companies needed to be bailed out.

More pressure on the Fed. More pressure on the markets.

Credit crunched. And that's more or less how it happened.

As I said at the start, this is one view of the underlying causes of the crisis. There are other views out there. I plan to cover that via book reviews (I know - cheating). But there are a lot of books out there on this story. Certainly, too much for me to summarise in blog post form.

Where to from here?

America's Debt Ceiling. After all, the Fed was busy bailing everyone out: the money had to come from somewhere. And despite the rhetoric, it hasn't come from the taxpayer's pocket.

At least - it hasn't yet.

Credit-Default Swaps: the real issue with the Greek Debt Crisis

Recently, the Universe smiled at me. I walked into a small second-hand bookstore, and found a signed, annotated, mint condition, first edition copy of Nelson Mandela’s autobiography “Long Walk to Freedom”. I rushed off to change the limit on my bank-card, and half an hour later, it was mine. And really, I cannot deny that the purchase was motivated by the prospect of making a return post Madiba’s mortem. In fact, in those 30 minutes that it took to change the card limit, I was plagued by the real fear that news of his death might break before I could get back to the store and seal the deal.

So it seems that I now have a vested interest in Mandela’s death. Is that a pleasant thought? Perhaps not. But then, I like to be pragmatic about these things. Investments are investments.

But despite my vested interest, would I go so far as to act on it? Well, no. That sounds like a lot of effort. And I’m sure it would cost more than any gain that I could make. Pragmatically speaking, of course.

Now what does this have to do with the Greek Debt Crisis? Well – it comes down to a question of vested interest. Up and until around 2005, the aim of investing was to reap gains when the market goes up, and limit losses when the market goes down. The market rewards you with gains when you make the right call on the market improving; and it rewards you with no losses when you make the right call on the market crashing.

Evidently, at some point, someone began to notice the logical inconsistency there. Essentially, you bet on the market going up, you stand to make money; you bet on the market going down, you sell off your investments, and you make no money at all (but you don’t lose anything either). And someone says “you know what, I also want to be able to make money when I call, correctly, that the market is going to crash”.

That desire sounds a lot like wanting to buy an insurance policy. For example, when I insure my car, I pay my insurance company monthly premiums, and in the event that I crash the car, they pay for the repairs or the replacement. That is: I am betting on my car getting damaged in an accident; and the insurer takes the other side of the bet, saying that I won’t. Or, at least, they say that with enough people paying car insurance premiums, it is statistically unlikely that enough cars will be damaged in order to make them make a loss.

So someone takes this idea and says, “You know what – that guy over there with the drinking habit – I reckon that he’s quite likely to have a car accident. Can I take out insurance on his car? I’ll pay you monthly premiums, and in the event that he crashes, you pay me the value of his car”. What is the problem here? We’re removing the requirement of ownership. In that situation, there is no limit to the number of insurance policies that can taken out on that car, other than the insurer’s willingness to write them.

And that, more or less, is a Credit-Default Swap (CDS). I take out insurance against losses on someone else’s investment.

Let’s take, for example, a 10 billion euro bond issue by the Government of Greece. I look at the fundamentals of the Greek fiscal situation, and I say to myself “you know, they’re probably not going to be able to sustain the schedule of repayments”. So I approach a financial institution, and enter into a CDS over those bonds. In terms of our arrangement, I pay an annual premium; and should the Greek Government fail to meet its schedule of repayments, the financial institution will pay me the full value of the bond issue. The key points:

1. I never have to buy the bonds.
2. I just pay an annual premium (a percentage of the value of the bonds issued – say 0.025%, or 2.5 million Euros) in return for the potential payoff of the entire bond issue (10 billion Euros).
3. Any failure to meet the schedule of repayments (even if, for example, the Greek Government is a day late for one of its quarterly repayments) will result in the payout (these situations are known as “default events”).
4. There is no limit to the number of CDS instruments over that bond issue, other than the financial institution’s willingness to grant them.
5. I now have a vested interest in Greece’s default.

Now this seems to be a raw deal for the insurer. Why would any financial institution enter into these contracts? Well, for starters, governments almost never default on their debt, so the statistical risk of a default event is empirically low. Secondly, the gentleman doing the deal at the financial institution is probably going to be in line for a bonus every year – a bonus based on the volume of business he does, or the value of the premiums he brings in. Is he incentivised to avoid CDS transactions? Not at all. They result in a constant inflow of premiums, with very little historical outflow.

But this justification is flawed. The historical evidence for government defaults includes a time before Credit-Default Swaps. That is, a time without a vested interest in any one country’s default. CDSs were only created in around 2005, by investors wanting to bet on the failure of America’s mortgage-backed securities (investors who reaped their rewards in the Subprime Crisis). There is therefore a mismatch between the risk, and the justification for taking it on.

But now it is too late for that realisation to help. The CDSs were written. And now we find ourselves in a situation where an unknown number of investors hold an unknown number of credit-default swaps. All these people stand to gain in the event of default. It has been suggested that the number of CDSs written, if cashed in, could exceed the value of the world’s money supply.

It’s theoretically possible that Greece’s default could trigger the collapse of the entire world’s financial system. The Subprime crisis almost did – but that was before most investors saw the potential gains inherent in credit-default swaps.

The CDS may well be the beast that brings Financial Armageddon.

Someone needs to ban it indefinitely.

Once I’ve sold mine. 

(As an aside, the practice of short-selling was and is a way of making money when the market crashes – but the potential gain is limited by the number of stocks available to be short-sold. In other words, there is a physical limit – the number of shares – to the potential gain).