Earlier this year, Deutsche Bank quietly decided to reduce its exposure to Italian government bonds. But it did not do that by simply selling debt; instead it achieved this partly by buying protection against sovereign default with credit derivatives contracts. That duly enabled the doughty German giant to report that its exposure to Italian sovereign bonds had dropped an impressive 88 percent during the first half of the year – at least, when measured on a net basis – from 8 billion euros to less than 1 billion euros.
So far, so sensible; or so it might seem. But there is a crucial catch. These days, it is becoming less clear whether those sovereign CDS contracts really offer effective “insurance” against default. And that in turn raises a more unnerving question: if the exposures of the large European banks were measured in gross, not net, terms, just how much more vulnerable might they be to sovereign shocks? Or, to put it another way, could the problems now hanging over euro zone banks and bond markets be about to get worse, due to the state of the sovereign CDS sector?
The issue that has sparked this debate is, of course, Greece. In October, euro zone leaders announced that they intended to ask investors to swap any holdings of existing Greek sovereign bonds for new bonds, with a 50 percent haircut. Logic might suggest that a loss that painful should count as a default. If so, logic would also imply that it merits a CDS pay-out.
After all, the whole point of credit derivatives – at least, as they have been sold to many investors in recent years by banks’ sales teams – is that they are supposed to provide insurance for investors against the risk of a bond default. And there is a well developed mechanism in place, created by the International Swaps and Derivatives Association, to make such pay-outs in a smooth manner. That has already been activated over six dozen times for corporate CDS; just last Friday, for example, the process was activated for Dynegy, a corporate entity which recently declared bankruptcy.
But Greece, it seems, is different from Dynegy; at least, under ISDA rules. When the eurozone leaders announced their plans to restructure Greek bonds they failed to meet – or, more accurately, deliberately missed – the fine print of “default” under ISDA rules. Most notably, the standard ISDA sovereign CDS contract says that pay-outs can only be made when a restructuring is mandatory, or a collective action clause invoked. However, it seems that 90 percent of Greek government bonds do not have collective action clauses; and the October 26 announcement presented the haircut as “voluntary”. Thus ISDA has concluded that “the exchange is not binding on all debt holders”, so the CDS cannot be activated – even though losses on Greek bonds may well be bigger than at Dynegy.
Many investors, unsurprisingly, are outraged; some observers, such as Janet Tavakoli, a consultant, conclude that the saga has exposed the CDS market as a sham, with ISDA acting in bad faith. But ISDA officials vehemently deny this – and insist that the blame lies with eurozone leaders, and their determination to manipulate the fine print of the rules. “The obsession with avoiding a credit event [to activate CDS contracts] is, in our view, misguided,” the lobby group declares in a recent, unusually pugnacious, statement. After all, ISDA officials add, the published value of outstanding Greek CDS contracts is “only” $3.7 billion. Since that is partly collateralised, ISDA thus concludes – ironically – that even if that October 26 announcement had actually activated the CDS contracts, it would have barely affected the markets at all.
ISDA may well be right; given the magnitude of the turmoil now shaping the eurozone financial system, $3.7 billion is barely a rounding error. But the crucial question now is what happens to the wider sovereign CDS market – and banks. It is unclear how far euro zone banks have used CDS to hedge their exposures to euro zone debt. However, the published level of outstanding sovereign CDS for Italy and France is more than $40bn, and the Bank for International Settlements recently suggested that US banks have now extended over $500 billion worth of protection to euro zone counterparties on Italian, French, Irish, Greek and Portuguese sovereign and corporate debt.
For the moment, nobody is questioning the value of those hedges against corporate risk; the corporate CDS still appears to work relatively well. But the longer that the wrangle about Greece continues, the harder it will be for banks to argue that sovereign CDS is a good hedge for their counterparty or credit risk. If so, it is a fair bet that banks such as Deutsche (among others) will redouble efforts actually to sell those euro zone bonds – or demand collateral from sovereign entities for derivatives trades. Indeed, behind the scenes, these efforts are already quietly starting. It is not a comforting thought; least of all when a mood of panic is afoot in Europe’s debt markets.