Thursday, November 3, 2011

Credit Default Swaps

Sometimes readers need a pictorial explanation in order to fully grasp an important concept. In this case, we would like to help you understand what is really happening in the sovereign debt markets. This picture is an effective representation of the circumstances that several multinational banks are facing. This particular structure was a neighbor of MF Global until Monday.

Most of the New York banks, especially the primary dealers, are levered at a rate of more than 20:1 with respect to their base capital. This means that a $5,000,000,000 capital loss can completely wipe out a $100,000,000,000 balance sheet.

Traditionally, sovereign debt is treated as a very stable asset on the balance sheet. Maximum borrowing privileges are typically extended to these assets. Recently, riskier credits have been appealing due to their marginally higher coupons. When risk was questioned, Ivy League executives lashed out accusing heretics for failing to understand the difference between gross and net exposure to risk.

Lets say that back in 2010 a firm bought $500,000,000 worth of 10-year Greek debt that carried a coupon of 10%. This was seen as a smart trade because if readers remember the Greeks estimated that $80-100 billion would solve their temporary issues. Think back to the events occurring in the spring of 2010.

The purchasing institution will seek to protect this asset using a derivative product called a Credit Default Swap. This is an insurance policy that is designed to pay the purchaser in the event that the issuing nation defaults on its obligation to perform as promised. MF Global had significant exposure to Greek, Italian and Spanish credits on its books. Late last week, holders of Greek bonds received a 50% reduction in the value of their investment as a condition of further assistance. The International Swaps & Derivatives Association determined that this was a voluntary event and therefore did not constitute a failure to perform by the Greek government. What is confusing for us is that the event did not seem voluntary?

Immediately following the decision, banks holding Greek debt instruments would legally have to make adjustments on their balance sheets reflecting the new valuation. In reference to our example above, a firm holding $500,000,000 in Greek debt would be required to take a $250,000,000 loss. This was a death blow for MF Global. Margin calls forced the firm to file for Chapter 11 protection late Sunday night.

The Italian government is facing problems far larger than Greece. Italian debt has eclipsed 120% of GDP and Italian GDP is six times that of Greece. More firms will be affected by the ongoing events in Europe. The problem is simple: these nations are over-leveraged and there is no possible way to proceed without a direct devaluation of their debt.

When you hear a firm discussing Net exposure, keep asking questions. We are interested in Gross exposure. If credit default swaps are not going to pay out on the debt devaluation, gross exposure is what matters. The gross exposure to European credit could wipe out several large institutions. Some would assume that this incident would be isolated, affecting only the holders of the paper who should have known better. Don't be surprised when your money market account is inaccessible.

We continue to seek shelter in an asset that is not the liability of any other party, especially a power hungry, underfunded, and over-extended government.

1 comment:

A. said...

Once again a brilliant analysis.
Thank you