Debunking Some Myths About The "Greek CDS Contagion" Threat

Tyler Durden's picture

Now that the Greek bailout is topic front and center for the second year
in a row, it means that it is time for the mainstream media to once
again prove to the world that in the past year it has learned precisely didley squat about
how the more complicated securities used in capital markets operate.
Such as CDS. Just like in May 2010, the prevalent trope among the clickbaiters
is that CDS written against Greece will destroy the world, in
superficial attempts to bring about panic induced by the faulty
conventional wisdom that CDS was the cause for the implosion of AIG.
Well, wrong.

First, for those who actually care, CDS is nothing more than a low margin synthetic method to express a bearish position on an underlying credit (such as US government bonds), in the process facilitating market clearance and price discovery. Period. And as long as there is an idiot who is willing to take the other side of a trade which expresses nothing more than appreciation of risk, CDS can be written into existence (which is how Paulson made his Abacus money) or traded on the secondary market (the fact that said idiot is still trading CDS is thanks to the US government policy of making financial risk and failure a thing of the past, but that is the topic for another post). Another key CDS feature that is constantly ignored by nearly everyone is variation margin, or the daily posting of cash collateral based on intraday moves of CDS. This was extensively discussed in our post on the threats posed by the $600 trillion OTC market. A third key fact is that all the data on Greek CDS is publicly available yet nobody bothers to actually check it: after all why let facts stand in the way of a good story. So here are the facts: there is $5 billion in net notional daily margined risk exposure on the Hellenic Republic (also known as Greece). This is a 28% reduction in net notional risk over the past year, the largest drop in risk exposure of any of the top 30 credits tracked by DTCC. The total notional of Greek CDS outstanding is the 21st biggest in the world, behind such names as Italy (at the top), France, Spain, Goldman, JPMorgan, Berkshire and Wells Fargo. Lastly, 5 Year Greek CDS (at last check about 45 points upfront) is currently trading wide of cash bonds, which upon an event of default will likely rise on short covering and higher recovery expectations, which means that sellers of protection will actually receive a cash payment from this point until an actual EOD occurs when the basis between cash and CDS collapses.

The truth is that there is certainly risk from a Greek contagion effect, and far more than a risk -  it is a certainty, and the catalyst will be none other than the world's largest and most undercapitalized hedge fund - the ECB, which holds tens of billions of Greek debt as cash collateral which would have to remarked 50% lower in the process making the key European liquidity backstopper insolvent (in practice if not in theory: after all the ECB will just print more €), forcing a self-fulfilling liquidity run prophecy. But the contagion risk is not in Greek CDS, where risk sellers have not only contracted their exposure by the largest amount of the most active contracts, but where daily steady cash outflows to satisfy variation margin mean that banks have "overreserved" for an event of default, and may in fact be cash inflow beneficiaries.

As the DTCC-sourced chart below shows Greek CDS has seen the largest drop in net notional outstanding among the 30 largest positions. Furthermore, as can be seen it is well down on the table. The names in the top 5 positions should be a far greater source of risk, as that is where the perception of risk, and the market "reality" have not yet converged.

Most important, at least in our opinion, in the table above is not the 21st ranked name, but the 26th one, which has seen the change in its net notional CDS outstanding increase by 136%, or the most of the top 30, over the past year.

It should be rather obvious which "entity" is ranked #26... soon to be #1.

And for those who missed it, such as the entire mainstream media, here is your guide to the uber secret intricacies (yet completely public to those who search) that actually happen in CDS daily margin flows.

CCPs typically rely on four different controls to manage their
counterparty risk: participation constraints, initial margins, variation
margins and non-margin collateral.

A first set of measures are participation constraints, which aim to prevent CCPs from dealing with counterparties that have unacceptably high probabilities of default.

The second line of defense is initial margins in
the form of cash or highly liquid securities collected from
counterparties. These are designed to cover most possible losses in case
of default of a counterparty. More specifically, initial margins are
meant to cover possible losses between the time of default of a
counterparty,8 at which point the CCP would inherit its positions, and
the closeout of these positions through selling or hedging. On this
basis, our hypothetical CCP sets initial margins to cover 99.5% of
expected possible losses that could arise over a five-day period. CCPs
usually accept cash or high-quality liquid securities, such as
government bonds, as initial margin collateral.

As the market values of counterparties’ portfolios fluctuate, CCPs collect variation margins,
the third set of controls. Counterparties whose  portfolios have lost
market value must pay variation margins equal to the size of the loss
since the previous valuation. The CCP typically passes on the variation
margins it collects to the participants whose portfolios gained in
value. Thus, the exchange of variation margins compensates participants
for realised profits/losses associated with past price movements while
initial margins protect the CCP against potential future exposures.
Variation margins, typically paid in cash, are usually collected on a
daily basis, although more than one intraday payment may be requested if
prices are unusually volatile.

Full link for the above.