In this week’s Barron’s, Alan Abelson looks askance at the non-default default in Greece.

All bombast aside, what makes this issue so fascinating to me is not whether or not Greece has or has not technically defaulted. Rather, it is that there is a committee of conflicted interested parties rendering a verdict on that issue.

Funny, that sort of group declaration is not required when a payout determination occurs when a futures contract or an option must settle.

No committee decision is required. Which (again) is why Credit Default Swaps sound a lot more like Insurance than they do other tradeable assets.

Regardless, here is Barron’s:

“Rogues lying wasn’t the problem with another recent instance of March Madness on foreign shores. A panel of five investment firms and 10 banks chosen by the International Swaps and Derivatives Association has told the world it need not fear that Greece’s failure to pay its humongous debts would trigger payments mounting into the billions of dollars on those instruments of mass destruction, credit-default swaps, thanks to those 15 worthies unanimously declaring such losses are not “a credit event.”

Keep in mind, please, that credit-default swaps presumably serve as insurance against loss for holders of bonds and sovereign debt. But the panels saw fit out of the goodness of their hearts to make an exception for Greek debt. If something that would touch off payments of over $3 billion doesn’t qualify as “a credit event,” what is it then—a walk in the park with Angela?

Barry Ritholtz of Fusion IQ reminds us in his latest dispatch of the epic credit-default-swaps folly indulged in by AIG not all that long ago when the firm wrote upwards of $3 trillion worth of them, while “reserving zero dollars against potential claims.” It provided a bonanza for the insurer until the whole house of cards collapsed. At that point, AIG went belly-up and good old Uncle Sam found himself on the hook for a bundle. As to the definitional high-jinks engaged in by the panel on Greece to avoid touching off an avalanche of credit-default payments, Barry fumes: “Damned if I can figure it out.”

Why does it matter if Credit Default Swaps are not Insurance?

The key to that question is what the state insurance regulators actually from insurers — reserves (a lot of them) to make payments in the event of any such credit event occurs. Industry groups (ISDA included) do not require reserves. Not one penny.

Why does that matter? Swaps are ALOT less profitable as an insurance product than they are as a trading vehicle. THAT is the primary issue which we all should be concerned about. Its how AIG got itself into so much trouble, and we could very well see a repeat unless this gets resolved sooner than later.


March Madness
Barron’s MARCH 3, 2012

Category: Bailouts, Credit, Derivatives

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

9 Responses to “When is a Debt Default not a “Credit Event?””

  1. eddiebe says:

    Doctor to patient: You have a cancer we need to operate right away to guarantee your survival. You have insurance right?
    Pacient: I do have insurance, here is the information.
    1 week later

    Doctor: I’m sorry, your insurance carrier has denied paying for your operation, so we can’t proceed.
    Pacient: $%&^^#%&&^$%&^%&&!!!!

  2. Winston Munn says:

    I propose the ISDA be renamed the Lewis Carrol Commission:

    ‘I don’t know what you mean by “default”,’ Alice said.

    Humpty Dumpty smiled contemptuously. ‘Of course you don’t — till I tell you. I meant “there’s a nice delayed payment option for you!”‘

    ‘But “default” doesn’t mean “a nice delayed payment option”,’ Alice objected.

    ‘When I use a word,’ Humpty Dumpty said, in rather a scornful tone, ‘it means just what I choose it to mean — neither more nor less.’

    ‘The question is,’ said Alice, ‘whether you can make words mean so many different things.’

    ‘The question is,’ said Humpty Dumpty, ‘which is to be master — that’s all.’

  3. mbrmd says:

    One of the ironies of our “information age” is that there is precious little news, explanatory analysis, or even educated views available that aren’t cast through an obligatory and annoying red or blue lens.

    This is particularly true on complex topics like behavior in the financial realm, where admittedly I (probably like many other readers) understand little other than having gut-level reflexes that hubris-borne shenanigans seem to be taking place.

    Please keep up the good work.

  4. fraud guy- also says:

    I’d like to repeat the question that I asked in the comments of another recent Ritholtz post on CDS:

    Whatever happened to the commitment, made by Eric Dinallo, NYS insurance commissioner in the fall of 2008 to the US Congress, that NYS would begin regulating CDS as insurance products?

    If this hasn’t happened, it seems like it must be an epic failure to uphold the public interest in the face of monied interests.

  5. Jim67545 says:

    It seems that the key question to the discussion is, “was there a default?” A bond, note, loan, etc. is a legal contract between a lender and a borrower. They agree to certain terms as in “I agree to lend you $XX for YY months and you agree to repay me and pay interest under the schedule below.”

    As with any contract, it can be modified by agreement by the two parties. As long as unusual duress is not present making agreement by one party legally invalid, the terms change to what is newly agreed. This is not a default, no matter that either party may be uncomfortable or unhappy. Even forgiving payments, interest, etc. is not in and of itself a default and, in fact, it might erase a condition of default and reset the situation. Simple example: a borrower might be in default because they allowed insurance to lapse on a damaged vehicle but the borrower offers and the lender agrees to take some other substitute collateral. These kinds of things are pretty common in the realm of work outs in lending.

    Further, as we have seen with short sales, even an agreement by the lender to accept as payment in full, less than the amount owed, is not a default since this is freely agreed to by both parties, unhappy though they may be.

    I certainly do not understand all the nuances of this Greek thing but perhaps the above might shed some light.

  6. RW says:

    Back in the old neighborhood folks who welshed on their bets had their fingers broken and things generally went downhill for them after that unless they covered both the bet and the additional vig for wasting a good fella’s time.

    The flip-side of that being that those who can’t force a lost bet to be covered have no business making the bet in the first place.

    So I’m not particularly confused about when a default is a default — somebody is welshing sure enough — as I am confused as to why anyone bought these swaps in the first place: They don’t seem to be a derivative much less an insurance policy and, regardless of what they are, they don’t appear to be enforceable.

  7. haileris says:

    You know, thinking about this, if there was political pressure to not implement regulatory restrictions on the CDS markets, this is a plausibly effective way to severely limit the size of the market.

  8. leon38 says:

    At this stage the PSI proposal is voluntary. When the Greek government activate the newly-voted ‘Collective Action Clause’ to force the hold-outs into accepting the new conditions, the CDS will very probably trigger. Alternatively if the PSI doesn’t go through and Greek can’t pay their March coupon the CDS will trigger too.
    Also let’s remind ourselves that the vast majority of CDS participants are marked-to-market, and fully collaterallised on this M2M.

    That said the CDS documentation certainly isn’t perfect, as demonstrated noticeably by the Thomson credit event in Q4 2009. No public information enabled to trigger ‘failure to pay’ for the Jun-09 contract. Instead we had to wait for a ‘restructuring’ to happen, which triggered but left the holders of short-dated CDS with a very small pay-out.

  9. farmera1 says:

    Not to worry the governments will bail out the banks. Think not, if the derivatives go down (all $700 trillion plus of them, the world’s economy goes down, I mean way down). $700 trillion in OTC derivatives is several times (maybe 15 times) the entire world’s GDP. You honestly think there is any chance these things would pay off, nope not a chance.