Guest Post: Greek CDS - Missing The Forest For The Trees

Tyler Durden's picture

From Peter Tchir of TF Market Advisors

Greek CDS - Missing The Forest For The Trees

There appears to be growing momentum for a Greek restructuring.  It can be called a reprofiling or soft restructuring or hard restructuring, but in any case it seems that the likelihood of some debt being restructured is fairly high.  The ECB seems most opposed to any restructuring, though more and more, the ECB position, looks like a feeble attempt by Trichet to bury the fact that his open market purchase program has been a total disaster.  The other complication is some misguided attempt to effect a restructuring, while trying to avoid triggering a CDS Credit Event.

Any attempt to specifically avoid triggering a Credit Event is misguided at best, and possibly very damaging to the banking industry the EU finance ministers are trying to protect.

The Greek CDS market is actually fairly small.  According to DTCC, there is only 3.8 billion euro of net CDS exposure on the Hellenic Republic. That compares to almost 300 billion euro of debt outstanding.  There may be some additional exposure to Greece cds since it is included in SOVX, but the Greek portion of net SOVX exposure is very low, and some of the exposure is offset by investors who trade 'cds index arb'.  Not only is the 4 billion euro of exposure relatively small, most of it is held in mark to market accounts, so a lot of the loss to the system is already accounted for.

Not only is the exposure fairly small, as I have argued already, I suspect that CDS at this stage is actually transferring risk out of the banking system and into other areas.  I believe banks are now net short Greek credit via CDS.  Banks will benefit from triggering CDS as they will monetize those gains against losses in their bond portfolios.  The losers from a credit event would be insurance companies and hedge funds as I believe both of those areas are now net sellers of Greek CDS.  At one time, clearly, hedge funds were net short Greek CDS, but with 5 year CDS trading at 25 points up front and 500 running, a lot have taken profits, and some have made the bet that the EU governments would do something stupid, like avoiding a Credit Event. 

If a bank owns 2 years Greek bonds and 2 year CDS they are hedged and would receive regulatory capital relief.  If they are forced to extend their bond but are not allowed to trigger their CDS they have a serious problem.  The bond will decrease in value, because although the Greek yield curve is inverted, the price of front end bonds is much higher than longer dated bonds.  The CDS would gap tighter as no one would want to own CDS in an environment where finance ministers purposely structure around it, so the banks would have a loss on their CDS and a loss on their bond.  Then, adding salt to the wound, they would see a jump in their regulatory capital as the maturity mismatch of their bond vs their CDS would be too great and they could not claim regulatory capital relief from their protection.  This seems like the last thing the governments want.

So the size of the net exposure is fairly small, and if anything, avoiding a credit event is likely to hurt banks more than help them, why are they doing this?  Is it concern that a credit event will scar the reputation of the eurozone?  Maybe the public will be tricked by a reprofiling without a credit event, but the investment community that matters will see right through this.  If anything, the eurozone would lose credibility by trying to play word games and spending so much time trying to violate the credit derivative market. 

Since the net exposure is small, banks are likely beneficiaries of a credit event, and markets will see through this feeble attempt at avoiding the stigma of a default, the EU finance ministers should stop worrying about how a restructuring will impact CDS.  They should focus on restructuring in a way that provides the best possible outcome for Greece and creditors and not worry about what happens in the CDS market as a result.  If after sorting out the Greek situation, they still have time to think about CDS, they should spend that time figuring out who sold the protection and why?  For every evil, vile, nasty, hedge fund who had bought credit protection, someone took they other side and sold protection?  If the purchasers are so evil, does that make the sellers angelic?  The ECB shouldn't vilify a product but they should figure out why the sellers exist and if they want to revise the market over time, they should examine that side of the market as closely as they examine the buyers of protection.  And once again, I think any bank that holds greek bonds in a non mark to market account and is still a net seller of Greek CDS should receive close scrutiny from its regulator.     

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Howdan's picture

Very interesting and detailed analysis although i've been wondering : Who on earth is selling CDS protection on Greek Govt Bonds and how, if they are, do they hedge it?


Maybe some people see spreads tightening back if Greece is granted more aid/only has a "soft" restructuring and avoids triggering a credit event (as defined by CDS guidelines) ??


Thanks for the info anyway....

jm's picture

Who would sell? Some guesses...

Basis traders about to get their faces ripped off.

Someone with nothing to lose and an inventory of GGBs that they can't unwind that makes for good CTD.  Maybe thinking they can collect a few months premium on what they have already marked to zero.

ECB, Fed, etc. -- elephants with other poeple's money to burn or printing press and don't care about a few billion here or there.


Howdan's picture

Cheers jm


I laughed at your comment about basis traders.....I remember speaking to some a few years ago when they were wetting their pants over some "guaranteed" negative basis trades which ultimately blew up in their faces

Greater Fool's picture

A lot of the credit protection in the market ultimately comes from pension funds and other real-money investors. It's a way to go long the debt without having to actually find it--or fully fund it--and since very few people in their right minds would buy protection and then purchase a bond to form a negative-carry hedge, the real-money guys can generate leverage by going long debt synthetically and not drive up prices in the process.

This is always the subtext when people talk about the impact of a big-name default in the CDS market: Your granny is the ultimate protection seller in a lot of cases.

Howdan's picture

Ahhh that makes alot of sense now.. Thank you for your answer - most informative!

Bindar Dundat's picture

Good to see some one who does understand. This is a great site!

cdskiller's picture

Credit default swaps should be illegal. Period. End of story.

topcallingtroll's picture


MrPike's picture

I'll assume you would also be in favor of abolishing Puts on Treasuries? How then would Mr Bernanke keep rates low?

idea_hamster's picture

The Greek CDS market is actually fairly small.  According to DTCC, there is only 3.8 billion euro of net CDS exposure on the Hellenic Republic.

Sorry for the n00b question, but doesn't this "net" figure presuppose that all CDS counterparties perform?

I mean, if a bunch of the CDS shorts default (can't imagine that *cough* AIGFP *cough*) then those amounts can't get netted out against long positions, making anyone who has pass-through exposure now short and probably unprepared.

topcallingtroll's picture



StychoKiller's picture

France (and the UK) are probably juggling some spuds as well.

Ethics Gradient's picture

I thought the whole issue with CDS is that no-one knows how many are out there.

prophet_banker's picture

Thanks, somebody is on the same page as me.  You can't trust the DTCC to tell us how many derivitive CDS are on the market, they don't clear most of them..... most of them are off balance sheet transactions.  Worse yet, once the sharks smell blood, they will start naked shorting and buying CDS with out owning or trading the underlying asset, that's what made 2007 even worse.

cdskiller's picture

+1 Bang. They are evil instruments, in an evil market that can only operate in the dark and didn't used to exist.

oogs66's picture

I think the system can handle a Greek default.  Collateral provisions are much more strict that they were prior to the 2008 crisis, but even then, in spite of government, treasury, and media fears, the CDS market was the least of the problems post lehman.  The CDS market handled lehman bankruptcy remarkably well.  The much 'simpler' repo market had far more problems as a result of lehman, than the CDS market. 

Not only are margin requirements much tighter now, AIG FP was a fairly unique situation.  AIG had written massive amounts of protection on an underlying they never expected to make payments on.  As the underlying assets deteriorated, AIG FP didn't have to post margin because they had negotiated large thresholds for collateral so long as they remained above BBB.  When they got downgraded, suddenly they had to post massive amounts of collateral against a position they had rode all the way down and NEVER marked to market.  Had collateral been required earlier, they would have had to close out some of their position much earlier, making the whole situation better.  I believe that is what would happen for most counterparties today, so I do not think we will get any (or many) fails in event of a Greece CDS trigger.

The only institution that may still receive incredibly favorable terms on its derivative trades might just be Berkshire Hathaway. 

agent default's picture

The PIIGS defaults will be orchestrated in such a manner that avoids triggering the CDSs period.  Either that or sovereign CDSs will be banned within the EU.  Never mind the taxpayer, EU politicians have their reputations on the line here.  Not to mention that little idiotic EU project of theirs. 


Jack Sheet's picture

Interesting analysis and certainly timely, thank you. However, apart from the acronymitis (please, what are "DTCC" and "SOVX") there appears to be a plethora of assumptions and variables leading to the conclusion of no risk.

For example, I thought the whole paradigm of CDS including those for sovereign debt is that there is no transparency whatever. If it were transparent, all the sovereign CDS data should be available at the ECB web site. So how can DTCC (whatever that is) "know " that there is only 3.8 B€ CDs outstanding, and how can it be proven that they are "mostly held in mark to market accounts". Sorry, but it still smells fishy to me.

oogs66's picture

DTCC is a clearing house for credit derivatives.  Virtually all trades go through it.  It was part of a mandate in the mid 2000's to ensure that settlements and assignments went smoothly and to dramatically reduce the number of unconfirmed trades. 


Here is the link.  It is not as opaque as the media would have you believe.


Banks have trouble holding derivative trades in non mark to market accounts.  The regulations force them to put them in mark to market accounts.  It causes problems for bank risk management, particularly when markets tighten as they have losses on their 'hedge' but cannot monetize their gains on the underlying asset.  In times of spread widening it can overstate bank earnings.

Insurance companies would likely hold CDS to the extent they have them, in NON mark to market accounts.

Hedge funds and bank trading desks would have them in mark to market accounts.


rookie's picture

"The sovereign CDS market bucked the downward trend in notional amounts, posting a 6% increase.  This followed a 26% gain during the first half of 2010."

Scisco's picture

Now where is that article that explains how both sides of a derivative contact profit.

wjs90's picture

When the ECB first started talking about banning Sovereign CDS, volumes went way down.  It is much easier to implement a view on Sovereigns in the rates/bond or currency markets.  These days  Sovereign CDS being used for very short term speculation and mostly basis trades, its fairly illiquid and gaps easily.

I think all the focus on sovereign CDS is a way to distract from the real issue as any time you mention CDS you get the uniformed with their panties in a bunch crying how they should be illegal and are at fault for all things bad.  Expect any day to hear why CDS caused the earthquake and nuclear meltdowns.

As far as who is selling CDS. At this point its either market makers or people speculating on recovery rates.  5yr CDS trading north of 30pts upfront is just a play on what level haircuts come in at.  No different than buying the cash bonds at 50cents and playing the odds at the upside.  Don't think they deserve any more scrunity for selling CDS at this level than somebody buying the SPX in the belief the monetary authorities will get you whole.



rookie's picture

Sovereign CDS should have been banned a long time ago.  And you cannot possibly deny that CDS amplified the mortgage meltdown.  People like you should use your knowledge to fix our financial system and help reduce the risks, instead of choosing to keep doing the same thing and putting our financial system at risk . . .all for your own short-term gain.

wjs90's picture

Some products that contributed to the "mortgage meltdown": poorly u/w mortgages, asset backed debt, rate swaps, equity options, repo, and yes, CDS.  Lets ban them all, very logical idea.

Using CDS is just a way to express a view and the exposure can be replicated 10 different ways without CDS.  I do agree that CDS should be on some type of x-change with position limits.  CDS is a useful product both long and short.

IMO, the only real way to fix our financial system is to reduce the overall systemic leverage.  Of course that is the one thing the FED has been fighting every single day.  So its painful when people can throw out the words CDS and get this irrational fear response from so many and distract from the real issue.

jm's picture

I don't think the article was making a point to demonize CDS.  They exist because of the need for dealers and others to hedge credit risk on their books.  There has to be someone else on the other side of this trade to make it work, and neither should be demonized.

However, I think his final point is a good one.  If a bank holds an inventory of GGBs and they are selling CDS on them, it magnifies the impact of a default for the holder. 

A cynic could argue that it is a strategic decision to make losses so large they require a bailout, or at least a signal to someone that such is possible if they don't get desired liquidity.      

Zeilschip's picture

USA CDS is trading above 50 now...

sangell's picture

What about CDS exposure on Euro banks exposed to PIG debt?

Mr.Kowalski's picture

Sorry, but I'm not buying that one. As there is no real exchange to monitor these, nobody really knows. My guess is that it's at least $50B. Worse, as at least half of Greek debt is owed to their own banks, there are CDS's written on the banks as well.

CrashisOptimistic's picture

Nice layout, Tyler.  This is what we discussed a few days ago.

Some items of note, and I'm going to mostly stand down on this matter because I am no expert on DTCC's Derivatives Repository Ltd division or on their Deriv/SERV division.

Simply this: 

Transparency is not too impressive.  I have always had some doubts about measuring swaps via "net notional" because the "net" calculation by DTCC need not be the same counterparties.  In fact you would not expect them to be -- else the parties are not really taking any position at all.  In other words, assuming I understand DTCC's process, which may not be so, a small net notional can still bankrupt rather a lot of banks, while some others make out big.

The fear of default/restructure by the EU/ECB folks is very clear, and it derives from "contagion".  If this contagion were via more conventional, non swap, instruments, then why haven't those positions been closed out?  There have been literally years for the banks to do so.  There is growing, in my perspective, considerable evidence that the banks are refusing to do so and choose instead to terrorize Merkel and Sarkozy into maintaining the flow of taxpayer money (which winds up in their bonuses via the Greek/Ireland conduit).

In a much bigger perspective, the USD could not be allowed to collapse -- by the EU.  US exports would erase their (German, and Airbus) business.  The EU cannot be all that unhappy if the Euro falls to 1.25.



AldoHux_IV's picture

I agree with trying to figure out the best case scenario for Greece and its creditors (though creditors to a lesser degree). The problem is that you have a product like CDS where if it is properly regulated and held by the right people in the market a triggering event wouldn't be so catastrophic.  The system is set so that institutions can gamble more than hedge and herein lies the problem when you combine it with the fact that there is too much debt for an economy to function properly-- it is how things escalate and nothing ever gets solved.

The best thing at this point is to destroy the debt let the banking system/hedge funds/insurance companies take the loss, and policy makers need to refocus their efforts on repairing a broken system.  The market is broke, and the financial institutions are benefiting doubly from it: CDS gambling + ECB accommodations.  In our current system which is a zero sum game, the losers are the ones that need the help the most: the real economy.

This is why the euro is failing institution, and why our current system is failing-- all the incentives and priorities are geared the wrong way-- the financial system is predatory and cancerous rather than being a tool of utility.

gwar5's picture

Greece is a pretty face who should default already and launch another 1000 ships against the known world.  I hope Greece, Ireland, and Portugal stick together and default, stiffing the banks, and setting new terms for what 21st century banking will be like.

As long as the banks are always calling the tunes, and first in line, of course they'll set up countries to fail and squeeze them to death.