Halloween Derivatives Nightmare

Greek deal may imperil sovereign CDS market
The future of the Credit Default Swap (CDS) market -- used to hedge against the risk of a country defaulting -- may be at risk if these derivative instruments do not pay out after this week's rescue deal for Greece.

An implosion of the sovereign CDS market could lead investors to buy fewer government bonds because they feel they cannot protect themselves, and risks pushing up borrowing costs for governments, especially in the euro zone.

Private sector creditors such as insurers, banks and funds will take losses of 100 billion euros on their Greek debt holdings under a new bailout pact struck this week, sharing the burden of the costly rescue with taxpayers.

But the International Swaps and Derivatives Association (ISDA) -- a bank lobby that also decides whether an event triggers the CDS -- has said it's not likely that the restructuring would lead to a pay-out.

"The CDS market is being keelhauled. This certainly isn't going to help, because why would you buy a CDS if there will never be a payout?" said one well-placed industry source, referring to the Greek situation. He projected the sovereign CDS market -- a small corner of the $25 trillion overall market -- could die out in the next year, echoing some bankers' fears.
The problem banks and investors face is that the risk of sovereign defaults in the euro zone -- once inconceivable -- has grown more real in the past two years.

And if one of the main hedging tools disappears, that inevitably means they will be under even more pressure to reduce their exposure and start selling the bonds, pushing up the yield and therefore the financing costs for governments.
My view:

The borrowing game high flying governments have been playing may soon be grounded.

If a 50% write-down does not trigger a payout of a Credit Default Swap - how much of a write-down would be required?


This financial instrument meant to reduce risk is beginning to look much like the Mortgage Backed Securities of yesteryear.


How much is a CDS worth if one can't collect on it in the event of default?


Extreme leverage, both in the banking system and by government borrowing has multiplied the risks to a level we can not imagine.


Instruments like derivatives, that were supposed to reduce risk, have in fact increased risks vastly.


How long until the market wakes up to the hubris and reacts accordingly?

For more on Credit Default Swaps watch this video.





Comments

  1. Who recorded this? You can´t hear a thing. There´s two sources of sound playing at same time.

    ReplyDelete
  2. Sorry the sound didn't work for you Manuel. Here is the link on Youtube that allows you to watch directly from the source.

    http://www.youtube.com/watch?v=DdEI6PkGZK8

    ReplyDelete

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