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Elliott Morss | April 24, 2014

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What Has Really Happened to Euro Debt Insurance?

by Elliott R. Morss

Introduction

As I have indicated before, there is very little difference between the US bank collapse and the ongoing bank collapse in Europe: Banks latch on to a risky asset, e.g., mortgages or sovereign debt, buy it up, repackage it, and sell it off. Because the banks make money from a sales commission, they don’t care how risky it is. Until one day, the market disappears. That is what happened to mortgage-backed securities, and it has just happened for “weak sister” sovereign debt (the IMF reports that “…Shunned by financial markets and faced with deposit withdrawals, they survive only because the ECB meets in full their demands for liquidity against collateral of rapidly declining quality.”

Insurance

And oh yes. There is one other matter. Risk insurance. Remember AIG and banks that offered insurance on mortgage-backed securities? They are still digging out. How about the Euro sovereign debt crisis? Did anyone offer insurance? It appears so. It appears that a lot of insurance in the form of credit default swaps (CDS) was written.

Back in 2010, the IMF wrote in one of its reviews of the Greek situation:

“A credit event may reveal unexpected counterparty risks if sellers of default protection cannot live up to commitments.”

Well, we have had a “credit event” in the form of the complete collapse of the market for Greek sovereign debt. And the European governments have convinced their banks to take a 50% “haircut” on their Greek debt holdings. Are not circumstances like this the reason people buy insurance, like CDS’? Before answering this question, I quote from a piece I wrote a few weeks back:

Greek Creditors – When Is a Default Not a Default?

When you borrow money from someone, you write up a loan agreement saying how much you are borrowing, what the cost will be (interest), and when you will pay it back. A default happens when the debtor does not abide by the loan agreement. The Greek creditors have looked at Greece’s situation and have concluded it cannot handle the debt payments required by current loan agreements.

Consequently, the French and the Germans are trying to get all creditors to agree to new terms. In essence, they are trying to stretch out the debt so annual amortization payments will be lower. If they get this approved by most of the creditors, the old loan agreements will be torn up and new ones written. If Greece signs the new agreements, it will have defaulted on the earlier agreements. But the French and Germans prefer the term “rollover” to “default”.

Fast Forward to the Present – The Implications for Euro Debt Insurance

The European leaders have talked about haircut but not default. What does this mean? John Mauldin published a piece last week in which he said:

“And because the write-off was voluntary, there would be no triggering of credit default swaps clauses. Because if it’s voluntary it’s not a default – capiche?”

I wondered about this – when is a default not a default? So I sent the following question to a senior risk assessment officer in a major US bank: “Suppose I bought Greek debt. And fearing risk, I purchased a credit default swap. Now that the banks have agreed to take 50 cents on the dollar on debt, does this not qualify as “default” under a typical CDS, or are the CDS issuers off the hook?”

His response:

“You hit nail on head. Huge debate these days. Many contracts also say something to the tune of material disruption. To me it will be a crime if the Greek deal does not require a settlement/payment. Also, what’s to stop one of the euro banks who is in on the deal from selling me the bond at 60 cents and then I get paid at 100 cents because I have not accepted the optional haircut? Likely the banks had to fess up on some holdings, but I’ll bet not all of them.”

He just sent me this follow-up:

“When they announced the plan, the EU officials made clear it was an optional haircut the banks were taking – that meant it would not trigger default settlements under swaps. Very much a managed process (gun to the bank CEO’s head) to insure it was “voluntary”. But I do not think that is the end of the story.”

I don’t think so either. The groups that bought “CDS insurance” will not give up that easily. It is probably a good time for US and European financial lawyers. A very messy business.

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