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.

Contagion. And Why Greece is Contagious

So. That last post.

Some people were irritated.

In the aftermath, I was called a wolf in sheep's clothing (amongst other things); and the post was called "a rehash of selective information" "which offers no conclusive suggestions as to how to resolve the situation" and "was lacking in certain fundamental areas".

Which I found to be a bit unfair. Firstly, you're not really discrediting the argument by calling it names. And secondly, you can't attack an argument by attacking the person making it. The debating phrase in my head is "the ad hominem fallacy".

Also, to be frank, if patriotism requires me to be blind and sheeplike, then the wolf accusation is a compliment. After all, wolves and sheepdogs are not so different. Shun me if you wish; but I like to think that it's the wolves, not the sheep, that do well in a crisis.

In any case, I was sent a video link that offered an alternative viewpoint (Peter Economides - "Rebranding Greece"). If anyone is interested, you should youtube it - it's worth seeing a different perspective. Essentially, Mr Economides suggests that Greece has been unfairly singled out in the crisis - and that the Greeks are partly to blame for this. He argues that Greece must rebrand herself if she is to come through this. Mostly, I agree.

But I have some observations:

1. A branding solution unfortunately does not change the underlying fiscal crisis - in the same way that dying my hair dark is unlikely to help if I'm going bankrupt (even if the bank had a prejudice against blonds to begin with). While it may be necessary in the long-run - as a short-term solution, it requires more than just a change in look - we also need an internal dynamic shift to take place.
2. As an alternative to the current view that Greece has the highest default risk (a view based on Greece having the highest public-sector-debt-to-GDP ratio), Mr Economides uses a UBS analyst report on the likelihood of sovereign default. The report incorporates the public-sector-debt ratio, the loans-to-deposits ratio, and the credit-to-GDP ratio to create a quantified index of default likelihood. As a general point, incorporating the "loans-to-deposits" ratio of the private banking sector, whilst interesting, is not that relevant to longterm sustainability - it is the government that is going bankrupt. That ratio simply gives an idea of banking sector stress, which is linked to the level of reserves that the Central Bank/Reserve Bank will have available if the bankruptcy goes down today - not the underlying systemic fiscal crisis that will persist over time. From what I can see, the greatest index weighting has been placed on this variable.
3. In addition, the basis of the alternative viewpoint was a forecast generated by analysts at a bank. Using an analyst forecast to definitively dispute the actual fiscal data can be dangerous. This is not what Mr Economides is doing (he seems to be making a point about statistics and perception); but it is what some people are doing to justify their own views on the crisis.
4. Incidentally, I searched for this UBS report (the Andrew Cates' Aggregate Balance Sheet Risk Index) online - and while there is much reference to it, I could not actually find it. So, in all honesty, I am inferring some reasoning. But that said, every article I read that mentions the index includes the caveat that the index does not take into account all factors that affect the risk of default. 
5. Mr Economides states that after the Olympic Games of 2004, "we [Greece] started consuming like lunatics". This supports my original argument - although I also think that Greece would have been overboard on its spending before this. Olympic Games are not cheap to put on.
6. The human cost of this crisis is undeniable. But sadly, it is also unavoidable. Pragmatically speaking, any solution will limit rather than avoid human cost. Perhaps there is a certain hardness that comes from having lived through a real fiscal crisis - but people will survive, and will emerge stronger and more rooted in community.
7. Finally, I was never, at any point, attempting to imply that the Eurozone debt crisis is purely a Greek Debt crisis. But I do agree that it forms the focus of the media attention.

So I'm going to address that last part: why I think it is the Greek Crisis in the news, and why there is the potential for the rest of the world to interpret the Greek debt crisis as the Global debt crisis.

It is because, fundamentally, Greece has the largest relative public sector debt. We are not talking about the "likelihood of default" here - but the magnitude of the problem. And even if we were to accept the conclusions of the UBS report - that report would still lack a fundamental variable (indeed, it is the variable being pushed by Mr Economides): market perception. Regardless of whether it is justified, public perception considers Greece to be the most immediate default risk.

And that makes it the most immediate default risk. 

Two broad factors drive a share price: company fundamentals, and market perception. Two broad factors drive the cost of sovereign debt: national fundamentals, and market perception. And easily, market perception is the more dominant: because it thrives on emotion, paranoia, and our deeply ingrained animalistic instinct to stick with the herd. 

Given that, the question becomes: what is the market perception concerned with?

Answer: contagion. 

• Contagion is the spread of economic problems from one country into other countries with similar characteristics.

In this situation, a disorderly default in Greece would give rise to a contagion that would spread through the other indebted countries in the Eurozone. 

A simple series of events that we would call "contagion" could be as follows:

1. Greece defaults on its debt, triggering an immediate downgrading of its sovereign debt to junk status, as well as triggering the Credit-Default Swaps written over its bond issuances.
2. The ECB, most of the Eurozone Reserve Banks, and most international banks have Greek Debt exposure (ie. they have investments in Greek bonds). If these bonds default, it would call the credit quality of these institutions into question. There would be further downgrades in their credit ratings, and consequent increases in their cost of borrowing.
3. As the cost of borrowing increases, so the reserve banks come under further liquidity pressure. Any new borrowings will cost more; and some of their current assets would not be paying back expected cash flows (the Greek bonds in default).
4. Given the recent default, borrowers may be unwilling to buy up new debt issuances from countries with similar economic characteristics to Greece and/or they may not have the funds available to invest in them. This would cause liquidity shortfalls, and an inability of the at-risk countries to roll their debt (ie. borrow new money to pay back old loans - thereby keeping the level of debt constant).
5. These liquidity shortfalls could result in more at-risk countries going into default.
6. And so the pressure continues to build as each new country defaults, bringing about further defaults, and spreading the contagion.

So really, we're all concerned about contagion. And everyone is anxiously looking for the country that will kick it off. Which, at the moment, looks to be Greece in March 2012 (a large number of bond repayments fall due at that point - which is why everyone is so desperate for a deal before then). 

The Eurozone solution right now seems to be an orderly Greek default. If the default is orderly (ie. based on the debt negotiations) - expectations can be managed, and hopefully contagion will not spread. A disorderly default, on the other hand, will almost definitely give rise to a free-for-all. Hence the media attention.

And what, in my opinion, is the solution for Greece itself?

A miracle.

Because right now, Greece cannot earn in revenue what she already owes in debt, never mind what she intends to spend. I see one of two things happening:

1. Greece leaves the Euro, undergoes a collapse of her banking sector (bank runs are sure to happen in the period before leaving the Euro), monetizes her debt, and suffers through a period of inflation and/or hyperinflation (it will be her third experience of traditional hyperinflation); or
2. Greece suffers through the austerity program and recession in the hope that she can stay in the Euro.

Either way, there will be suffering. But austerity is controlled, whereas debt monetization is not. And at the very least, austerity may give some relief in the form of external funding from fellow Eurozone countries.

Finally, I am all for the Greek call to community. We should be rising up: rising up to help the Greek elderly. Because if the Zimbabwean experience is anything to go by, it is the elderly who bear the brunt of fiscal crisis. They are fully reliant on the State, because they are no longer in a position to react.

The Greeks must rediscover their community. If the cloud is to have a silver lining, it is the only way.

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).