Saturday, 21 January 2012

Credit Default Swaps

The Greek 'Government' is currently negotiating with its creditors in the financial sector for a writ-off of part of its debts. The Eurozone (i.e. Germany and France) suggested this should be 50% but the creditors are trying to reduce this and the Greeks are trying to increase it, hence the delay. But agreement has to be reached before the cash bailout from the Eurozone can be released. So there's a bit of brinkmanship going on. If Greece doesn't get the cash bailout, then Greece will default on its loans and the creditors lose, but the creditors don't want to give up more than they have to. The deadline is the end of next week sometime. The idea is that Greece gives its creditors new bonds which are worth less than the existing ones, and the bailout money buys them back.
But an ironic twist in this little fandango is that much of the Greek debt has been bought up by so-called hedge funds at a discount and the hedge funds have taken out Credit Default Swaps (CDS) to cover themselves in case Greece does default. What the hedge funds are doing is insuring themselves against a loss, although a CDS isn't exactly insurance. The buyer has to pay for them (single premium or a series of payments) but the seller carries out no actuarial risk calculation and the payout is not related to actual losses but is for the amount initially negotiated. So if you are a hedge fund with a CDS against a debt owed by Greece you get your money back - and perhaps more - whatever happens. So they are negotiating to see how much more than the original debt they can screw out of the situation. 
Now comes the weird bit. What the seller of a CDS does is hedge his bets by buying a CDS (or several) against his prospective loss, from someone else. And that person does likewise so that we end up with a chain of CDS arrangements that payout if Greece defaults or pays back less than it owes. Moreover, anyone else can buy a CDS against the Greece debt even if they are not a creditor (i.e. they don't actually own the debt). I fail to see how this can be a good thing. Everybody is betting against themselves and each other until eventually one financial institution or another gets lumbered with the bill - and I wouldn't mind betting that it will be the European Central Bank or IMF which are ultimately funded by.... you and me. And that's (amongst other things) how the credit crunch happened. And Greece gets off scot free.
It's all a bit like something from Alice's Adventures in Wonderland. As the Duchess said to Alice:
“... never imagine yourself not to be otherwise than what it might appear to others that what you were or might have been was not otherwise than what you had been would have appeared to them to be otherwise." The financial sector is indeed 'being what it seems'.
But never mind. David Cameron assures us that he and his chums in the Conservative Party understand all this and so he's best placed to fix it.

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