Oct

28

How is a 50% Mark Down on the Par/Redemption Value of a Bond NOT a Default?

[Ed.: for background information see for example Greece Default CDS Failure to Trigger ].

 Stefan Jovanovich continues: 

 "You don’t need everyone buying CDS to expect it to pay out, you just need a buyer of last resort who’ll make it pay out. You don’t need tons of short sellers to root out fraud, but you do need to allow short selling so that one or two clever and capitalized short sellers can bet against the frauds. You don’t need all the buyers to think the price is right, just the marginal buyer. Greek CDS “works” only in the limit case, only for a non-bank investor who’s willing to be a jerk and run a certain amount of politico-PR risk. But that doesn’t mean it mostly doesn’t work. It means it entirely works."

From a post by Matt Levine.

At the risk of being the jerk who still doesn't get it, the tape is not the world. The short sellers win because there is, in fact, a fraud - Baldwin-United, Enron, etc. really do not have the money or assets that can produce future profits even though their books say they do. Even without short-selling the fraud would ultimately produce the lovely worthless securities losses that can be deducted against ordinary income. The tape would catch up with the world.

With CDS for sovereign debts it seems that "the world" is what the financial authorities define it to be, not the reality of Greece's solvency. I can understand that people will continue to trade CDS because there is, in fact, a market for them; what I do not understand is why anyone believes "the market" in this case has any reality other than a virtual one.

Gary Rogan comments:

Stefan, there is a real reality that

(a) by itself Greece can't pay off it's debt

(b) there are all kinds of people that want to do something to improve it's ability to pay it off.

In this sense Greece is not Enron and the reality is not virtual. There is this strange technical point of what happens to the CDS's if "everybody" voluntarily accepts a 50% haircut, but even the resolution of this point is real, not virtual, so if you buy both the debt and the CDS's something real will happen if you hold the debt to maturity.

Stefan Jovanovich responds: 

There are two problems with this scenario:

(1) everybody will not voluntarily accept the haircut in the CDS market; somebody will want to collect in full from a counter-party because the sovereign debt that is being swapped has done a half-default.

(2) Greece's sovereignty does not guarantee its solvency -someone holding even the new debt to maturity may find themselves receiving less than par. That is the contingency that the hedging instruments were supposed to protect the buyers against.

Gary Rogan writes: 

True, but none of this is virtual any more than the currency in circulation is virtual, which is what you seemingly claimed/asked. There is posturing going on, and I'm sure fraud depending on how you look at it, but there is real money involved and those with the best information, and to a lesser degree instincts, are making real money. Can you imagine what a smart European flexion getting the information in real time can do? Sooner or later we are talking about real money.

 Stefan Jovanovich writes:

Some of us are old enough to remember the collapse of the commercial paper market around the failure of the Penn-Central. Perhaps the Z-Man and the others who are out there making money while us Social Security recipients are busy typing can answer these really naive questions: how long did it take for the non-financial commercial paper market to revive and did it, in fact, revive? I have no doubt that there is real money involved; there was real money involved in the commercial paper market and then…. it was all gone. Currency is virtual but it has legally-enforceable exchange value.

My naïve question was - and is-what is the legally-enforceable exchange value of a credit default swap if "credit default" never, ever happens. If the insurance company can rewrite the policies, with blessing of the insurance commissioner, the buyers for that insurance may decide to go elsewhere for their risk management. I know there is supposed to be a chair for everyone in the room except the last guy; but the history of markets is that some people stop betting on finding a seat while the music is still playing and "everyone" knows the game will go on forever.

Gary Rogan says:

Does it really matter to anyone not playing if sovereign Credit Default Swaps disappear from the face of the earth? It's an iffy concept in the case of US treasuries anyway. Who will be there to pay if off in the world where the US defaults? It's not like you won't be able to buy earthquake insurance in the East Bay, so put your mind at ease Stefan.

Stefan Jovanovich continues:

I never know when Gary is teasing. Earthquake insurance is no longer offered in California by private insurers because the insurance commissioner allowed homeowners to collect on damages from earth movement - which is a chronic problem in coastal California - even though that risk was specifically excluded from the coverage. As a result you must now buy your insurance from the State of California which, of course, people decline to do - given this sovereign's solvency. As to why it matters, the disappearance of what has been the primary tool for risk hedging may have effects as large as those that came seizing up of the commercial paper market. We owe those once in a generation bargains in 1974 as much to the inability of firms to borrow short-term as we do to Watergate and oil price surge - perhaps more.

 Ken Drees comments:

What is the percentage of uninsured homes and businesses in the earthquake probability zones? (guestamate is ok)

I find it ironic that the overdue earthquake area people are living by the dice roll.

Stefan Jovanovich responds: 

According to the Insurance Information Network of California, fewer than 12% of the state’s home owners had earthquake insurance last year, and fewer than 10% of businesses had the coverage.

I don't see the irony. Some risks are not worth the cost of insuring. This is one of them.

Russell Sears comments:

Perhaps I too am naive, but I thought this was obvious: If the messenger will not agree with the rues, extend and pretend, then they must be shot. Currency CDS /hedging /insurance contract was sacrificed for the sake of the Euro.

While there may be some value in the litigation options, currency CDS's going forward are a dead market are they not? Just like structured securities, if you cannot trust the contracts for being truthful, (in a practical everyday sense of the word, not legal twist) then they are dead.

Are we willing to live with liquidity of MBS and currencies being at the mercy of those sovereigns that still have some semblance of confidence in them? Can these sovereigns keep these bottomless guarantees "off-balance sheet" without it cracking them? The market seems to be saying for now, "yes".


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