What ISDA Got Right (and Wrong) About Greek CDS

In all the discussion about the Greek debt negotiations, one point that keeps coming up is the importance that the debt restructuring be voluntary so that the default clauses in credit default swaps (CDS) on Greek debt aren’t triggered.  I’ve never entirely understood this point, because the impact depends who the buyers and sellers of the CDS are.  If the debt restructuring is voluntary and there’s no technical default, there will be some winners and some losers, and vice versa if Greece is judged to have default, only the winners become the losers and the losers become winners.  There might be a case to be made that the shock to the system will be reduced if there’s no technical default, but I haven’t seen it.  (Maybe I’ve missed it.)

Regardless, what is true is that stakeholders in the Greek talks have a vested interest regarding the Greek default determination.  The question is, how much of an interest?  In one corner, we have Nobel laureate Joseph Stiglitz, who says that CDS exposure is a significant factor in the current negotiations:

There is, moreover, little evidence that a deep involuntary restructuring would be any more traumatic than a deep voluntary restructuring. By insisting on its voluntariness, the ECB may be trying to ensure that the restructuring is not deep; but, in that case, it is putting the banks’ interests before that of Greece, for which a deep restructuring is essential if it is to emerge from the crisis. In fact, the ECB may be putting the interests of the few banks that have written credit-default swaps before those of Greece, Europe’s taxpayers, and creditors who acted prudently and bought insurance.

Stiglitz also took a shot at the ISDA Determinations Committee, which will rules on what does and does not constitute a default, writing that “it seems unconscionable that the ECB would delegate to a secret committee of self-interested market participants the right to determine what is an acceptable debt restructuring.”  ISDA’s media.comment blog shot back:

As we have said many times and in many places, the $3.2 billion in net exposure of Greek sovereign CDS is relatively small. Plus: that $3.2 billion is the aggregate amount of all the individual net exposures, so the exposure of any one firm is less. Plus, plus: the exposures firms have to each other are marked-to-market and largely collateralized. Plus, plus, plus: the recovery value of a defaulted reference entity’s obligations further decreases the amount of cash that a protection seller would pay out to a protection buyer (so the aggregate cash payout following a credit event is less than $3.2 billion).

What does all of this mean? Simply that Greek sovereign CDS exposure is too small to be much of a factor in the Greek drama that is currently being played out.

We would have thought that Professor Stiglitz and his research staff surely know all of this? And that regulators have access to trade volumes and exposures through the CDS trade repository? And also that the EBA’s capital exercise, which detailed the CDS exposure of 65 European banks (including those from the UK, France and Germany) as of the end of the 2011 third quarter, showed that the total net CDS exposure of those firms was $545 million, all of which is already marked to market at approximately 30%?

ISDA says that the net notional amount of Greek CDS outstanding is $3.2 billion (which is to say, if Greece defaulted tomorrow, $3.2 billion would change hands between buyers and sellers of CDS on Greek debt).  The gross notional amount of Greek CDS is $69.5 billion, but due to the wonders of netting, the net amount is a fraction of that.  (These numbers are listed on the DTCC’s website here, in table 6 under “Hellenic Republic.”)

To put this into context, the total outstanding notional value of Greek debt held by private creditors is about 206 billion euros (US$270 billion).  So, on the broader point about the importance of CDS, it looks like ISDA’s right.  Greek debt worth $270 billion is going to matter a lot more than net CDS of $3.2 billion.  Score one for ISDA.

However…the fact that the net value of CDS is much smaller than the value of Greek debt doesn’t mean it that it doesn’t matter at all.  If creditors are basically resigned to a huge haircut but believe they have the power to affect whether or not Greece technically defaults, then they might care a whole lot about their CDS exposure.  And for stakeholders holding CDS but not Greek debt, the comparison between the two amounts is irrelevant.

I also have a small quibble with ISDA’s calculation of European banks’ net CDS exposure, which they calculate based on the EBA’s capital exercise.  It’s true that $545 million is the net exposure of the 65 banks included in the exercise, in that if you take the net positive exposure of all the banks and subtract it from their net negative exposure, you get $545 million.  But it would seem to me that a more important metric regarding the impact of the CDS on the banks would be their total net exposure, regardless of whether it’s positive or negative (i.e. the sum of the amounts that banks stand to gain or lose).   This amount is $1.7 billion (as of the end of the third quarter of 2011).  Again, not a huge amount relative to the value of Greek debt.

So for fun, let’s take a look at the individual net exposures of these European banks (all of the banks except for HSBC and RBS are net sellers of CDS):

The banks in red are on the ISDA Determinations Committee (again, at least as of 3Q 2011).  (RBS, in green, is a consultative dealer.)  To put this in context, BNP Paribas, which is shown here as being a net seller of US$91 million worth of CDS, wrote off 567 million euros related to Greek debt earlier this week.

In summary, when you look at the notional value of CDS, ISDA is right that it’s not as big a deal as everyone is making it out to be.  That doesn’t mean that we should ignore it entirely, but when trying to assess its impact on the negotiations, a little context helps.

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7 Responses to What ISDA Got Right (and Wrong) About Greek CDS

  1. George H says:

    Your link to the ISDA’s blog does not work.

    In your figure, the gross amount of Greek CDS is 69.5 billions. That is very different from the net. I am not saying gross is the net. But there is got to be some difference when we consider the gross amount, otherwise the lesson of Lehman has been completely lost.

    When we face a significantly larger gross, we must worry about counter party risk. After all, if one weakest link falters, the entire net is broken and the net amount can quickly escalate. Unless of course we need a government bailout right away. So it seems to me a bit less rigorous to simply quote ISDA.

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  4. Todd says:

    I thought only derivatives contracts originated after mid/late 2010 have to be marked-to-market. A recent article titled “Derivatives: Collateral Posting Not Retroactive” mentioned this by referencing Berkshire Hathaway, which doesn’t mark-to-market its $60B+ of derivatives. Well, it’s just a thought to consider.

  5. shubik says:

    Thanks George, I updated the link. You make a good point about counterparty risk. My assumption was that no one institution has net CDS exposure that’s large enough for it to fail in the event of a default. I don’t know how reasonable that is–I had trouble finding data on individual institutions’ exposure beyond the European banks in the EBA capital exercise. I would guess that none of the US banks are so foolhardy that their CDS exposure is so large that they’d fail in the event of a default and no hedge fund large enough to pose systemic risk would fail either. It’s something to keep in mind though when looking at gross vs. net exposure.

    Todd, thanks for the comment. My understanding of the figures in the EBA capital exercise and from the DTCC is that they refer to the total possible loss/gain in the event of a Greek default, regardless of how banks are marking the CDS on their balance sheets.

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  7. David says:

    to a reasonably intelligent non-financial pair of eyes this whole escapade looks just like ponzi-economics -lots of CDS positions without sufficient capital to actually back it up -i.e. far too much leverage

    what’s the point for society in letting CDSs exist if when they’re needed they fall through?

    of course that bankers benefit from larger bonuses full in the knowledge a bailout is coming…

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