Two-Way Street

Anti-Europe Debt Bets: Who is the Bookie?

There's a mystery a lot of business journalists would like to solve these days: Who is the bookie taking all the bets against Europe?

Question Marks

Why is the mystery so important? Because some fear the answer will be "another AIG." That could mean big trouble.

The bets come in the form of an ugly name, "credit default swaps," that covers a simple idea: Insurance against a certain country not paying off its debts. So if you own $10 million worth of Italian bonds and you are worried that Italy won't pay it off, you buy a credit default swap (right now it'd cost you a little more than half-a-million dollars). If it Italy doesn't pay, whoever sold you the CDS will pay off the $10 million.

So you see why many institutions that bought different types of European bonds over the years—various pension and mutual funds for example, as well as banks—might be interested in buying credit default swaps these days.

Of course, you don't have to own the debt at issue to buy a CDS. You can just buy one because you think a particular country is going down. That's when a CDS really goes from being insurance to being a flat out bet. And with Europe in the state it's in, many outfits (read: hedge funds) want to take the gamble.

But who is on the other side of these bets? Who is saying: "Sure, I'll take your half-a-million now. And if Italy defaults, I'll pay you $10 million"? That's worrisome.

"It's not a good situation," said St. Louis Fed President James Bullard on CNBC this morning. "The CDS markets are hard to trace. It's hard to figure out who is really holding the bag at the end of the day...that troubles me."

Sure, there's information about CDS prices on country debt. Heck we have a whole . But that comes from the buy side. The sell side remains elusive.

Leading up to the financial crisis of 2008 there was a spate of CDS buying against mortgage debt. It turned out the major bookie taking the bet was the insurance giant AIG. That led to a government bailout and a whole lot of "too big too fail" discussion.

Now some are wondering if another large company is selling all these sovereign debt default bets now, which may lead to another major bailout headache. Or are the CDS bets being sold by a collection of smaller outfits, like hedge funds. And if the bets get called in, will they just fold up and run leaving various investment funds and banks without the insurance they were counting on. (There is a ripple effect discussion here...did those outfits use the CDS insurance as justification for borrowing and investing even more money?)

Or is the answer somewhere in-between: A few major banks are selling the CDS contracts now, getting the short-term cash to bolster their books and hoping the Euro zone will sidestep defaults in the future?

The mystery was almost solved when Greece reached its "haircut" agreement with private investors in early November. Many thought taking a 50 percent loss on Greek bonds would be the "credit event" that called in all CDS bets. Then we'd get to see who was paying up...or running away. But the body in charge of making the call, the International Swaps and Derivatives Association, demurred.

So the mystery remains. It'd be major chest-thumping for the biz journo that answers the question. But as the Fed prez said, it's an opaque market. Probably the luckiest thing will be we never find out.