The Greek Bailout, the CDS Market, and the End of the World

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A not-so-funny thing happened on the way to the latest Greek bailout.

The terms and conditions of the bond swap Greece agreed to before getting another handout constitutes a theoretical default – but not a technical default.

That's not funny to CDS holders.

Greece hasn't defaulted (so far), but some of the buyers of credit default swaps, basically insurance policies that pay off if there is a default, claim the terms and conditions of the bond swap constitutes a "credit event" or default.

If it is, they want to get paid.

While on the surface this looks like a fight over the definition of a default, underneath the technicalities, the future of credit default swaps and credit markets is at stake.

In other words, the ongoing Greek tragedy is really becoming a global tragedy of epic proportions.

The Next Act in the Greek Bailout?

Here's the long and short of it.

Greece needs to make a 14 billion euro ($19 billion) payment on its huge outstanding debt on March 20, 2012.

The problem is Greece doesn't have the money, even after the previous 100 billion plus euro bailout.

If it doesn't make the payment it will be in default and all hell will break loose.

That means banks that hold Greek bonds won't get all their money back and they will have to write down Greek debts to zero.

That will trigger contagion as other countries in Europe will be seen as vulnerable to default too, and as panic in Europe grows from depositors trying to get their money out of insolvent banks, the spillover will infect world markets.

That's the case for contagion.

While cobbling together another bailout for Greece, this one worth 130 billion euros ($172 billion), the ECB, the EU, and the IMF (the Troika) are asking existing "private" bondholders, meaning banks and investors, to swap bonds they currently hold, with their high interest coupons, for bonds with half the face amount paying less than 4% interest.

The idea here is that there's no point in bailing out Greece with fresh money if it won't have enough money to make payments on the new debts it is incurring.

By swapping their existing bonds with a face value of 100 euros for new bonds with a face value of 50 euros (that's known as a 50% "haircut") and accepting a lot less interest, bondholders will be getting something as opposed to nothing if Greece defaulted and repudiated its outstanding debts.

The bond swap is being called "voluntary," meaning private investors will be swapping their bonds because they choose to.

There's only one reason to make such an unprecedented offer to existing bondholders, that's because if it wasn't voluntary it would constitute a "credit event."

Unanswered Questions Lurk Behind a Default

What constitutes a credit event is ultimately determined by a 15-member committee, known as the Determination Committee, within the International Swaps and Derivatives Association (a private group of derivatives dealers and bankers).

If the Committee says a credit event is a credit event, it constitutes a default and triggers the payment process, known as an auction, by which credit default swap holders get paid.

That's a global problem that nobody wanted to face and would likely trigger its own version of contagion.

No one knows exactly how much CDS paper has been issued and in the event of a default, who will owe whom how much, or if the counterparties that owe buyers of CDS insurance have the money to pay them.

So who bought a lot of this insurance? The banks that hold Greece's bonds bought CDS insurance.

Who did they buy the insurance from? Each other and hedge funds.

The problem is twofold when it comes to this scenario.

First, banks have been pretending that the Greek bonds they own and haven't marked down don't have to be marked down, because they have insurance on them.

Second, what will bank balance sheets look like if they have to pay out on the CDS paper they wrote, and what will they look like if they don't get paid by other banks or hedge funds that don't have the money?

What's more, what if there are insurance companies, like AIG (NYSE: AIG) that wrote them insurance and can't make good on it?

The unknowns are off the charts.

A Bad Situation Made Worse

In this case, it didn't matter how Greece was going to get its bailout money. What mattered was that it wasn't considered a "credit event," which would trigger the CDS contracts.

But, things got worse.

The ECB didn't want to take any hit or haircut on the 40 billion euros of Greek bonds it had bought to support the market. It swapped them with Greece for some new bonds that pay them less interest, but they didn't have to haircut the principal they're owed.

That was clever. You see, the new bonds they swapped for are, well, new bonds.

They aren't subject to the haircut that the private bondholders are being asked to take on the "old" bonds.

Nice trick, right? Yes, it was.

On top of that, as private bondholders got upset, it was decided that because not all of them might volunteer to take big losses, new, retroactive covenants would be put onto the old bonds.

These collective action clauses, or CACs, now allow a vote of 2/3 of existing bondholders to make decisions that all bondholders have to comply with.

All this is making CDS holders very angry. Well, not all of them.

The banks that wrote CDS insurance don't want to have to pay each other or anyone else. They'd rather hide behind the voluntary swap and get on with pretending Greece will survive.

But, by the ECB essentially screwing private bondholders by unilaterally taking a "senior" creditor position and by forcing collective action clauses on bondholders that never imagined buying bonds that had such clauses (they didn't when they bought them), the whole swap deal has created a hole in what constitutes a credit event.

Yesterday, the Determination Committee (made up mostly of the same big European banks that own Greek debt and wrote CDS paper to each other) determined the swap wouldn't constitute a credit event. Although they also said, that could change.

Even More Unanswered Questions

Now you know exactly how a de facto default doesn't become a "credit event."

The problem now is what to do about credit default swaps. Are they worthless?…

Will anyone ever trust them again as being legitimate insurance on credit instruments? What will happen to this $300 trillion market? …

What will this mean for less than stellar debt issuers who are able to sell their suspect bonds because investors could buy default insurance?…

What does all this mean for the sanctity of contracts? After all, bonds are contracts.

Global markets are going to have to figure out the answers to these questions and what it will mean for future markets.

Today, it is completely muddled.

The best we can hope for is that there's time to figure it all out before skeptical investors pack it in and sell what they have no control over and have no faith in anymore.

Unfortunately, the Greek tragedy is only the first act.

[Editor's Note: Shah Gilani's free newsletter Wall Street Insights & Indictments has been an overnight success.

If you're not already signed up for Insights & Indictments, subscribe by clicking here.]

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About the Author

Shah Gilani is the Event Trading Specialist for Money Map Press. He provides specific trading recommendations in Capital Wave Forecast, where he predicts gigantic "waves" of money forming and shows you how to play them for the biggest gains. In Short-Side Fortunes, Shah shows the "little guy" how to make massive size gains – sometimes in a single day – by flipping large asset classes like stocks, bonds, commodities, ETFs and more. He also writes our most talked-about publication, Wall Street Insights & Indictments, where he reveals how Wall Street's high-stakes game is really played.

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  1. Daniel K | March 2, 2012

    Note: Politicians are the only "Socialists" promising the people they can have it all for nothing because their neighbor will pay for it. But…Banker's are not "Socialists", they always want to get paid. That worked only for a little while in Germany and Austria in the 1920's then inflation grew more than 20 times and everydollar ( Peoples money) became wowrthless. In Desperation the German people elected Herr Hitler and his "National Socialist Party" (NAZI's) in 1936. How did that work out? Hey Look at Russia (U.S.S.R.) too under Stalin and his successors….eventually they went Bankrupt! Look at what Russia did to Hungary when they took it over in 1947 after WWII…the Hungarian "Pengo" thier dollar became worthless. A $500 Billion dollar note would only buy you a cigar ..no food. Now look at The EU, The real crime was again perpetrated by Germany and France who pushed one currency and unifying their socialism to capture domestic markets for their goods. Pushing more socialism on the neighbors nickel until the have less countries of souther Europe could not afford to pay the bill and their neighbors were all out of nickels.

  2. silvano | March 2, 2012

    hi !
    if the scenario you present comes true ,that is if greece cannot make the repayment and the contagion spreads, how do you think will this affect the housing market or value of property here in Australia ? i have a big mortgage on my house ,do you think it would be a smart move to do that or do you feel that after the dust settles the value will go up again in a few years time ?.
    sincerely
    Silvano

  3. Ron Tuggle | March 2, 2012

    The Greek deal does smell bad but what about the great deal the GM bond holders got when the idiot you voted for did his little deal to save his union voters. I wasn't following you when that happened so I don't know what your opinion was at the time it took place.

  4. curioussenior | March 2, 2012

    very understandable presentation of a very complex issue,

  5. Gordon Foreman | March 2, 2012

    Excellent article, but you failed to mention directly that the decision by the ISDA effectively destroys the very foundation of the "Value at Risk" or VAR model that supports the entire worldwide banking and financial system. "Yes we have exposure, but we're insured", now becomes, "We're exposed to risk," and it will be interesting to see whether the risk officers at various institutions attempt to take steps to mitigate these newly perceived risks, or whether they just take an immediate retirement and move to a tropical island before everything comes unglued.

    My take on the action is that the ISDA fully understands the ramifications of their decision, but a decision that the Greek haircut is a default would have caused the immediate collapse of some critical institution, so they kicked the can down the road a little bit in this manner as well. But I don't think that there is much road left.

  6. silvano | March 2, 2012

    hi !
    my concern is this ! would it be wise to sell a house with a huge mortgage under the current situation ?
    in the past decades we have seen housing prices doubling over a period of 7-10 years
    can we expect for this to repeat itself under the present world situation ?
    sincerely
    Silvano

  7. John Hopson | March 2, 2012

    What happens internally within a country like Greece to its employment/unemployment figures, such a crisis does not invite investment to generate income, and therefore most of the medium and small business is not surviving.
    Has Greece got anything worth investing in other than tourism that will generate income and taxes? This week Greece had an influx of German tax inspectors arrive; this is simply a case of closing the door after the horse has bolted.
    Where did the money go and can they bring it back if it has been removed illegally.
    What a shame this is happening to such a beautiful country with such wonderful people that are suffering because of the greed of few.

  8. Benton H Marder | March 2, 2012

    After the MF Global fiasco, we all knew this was going to happen. There never was any intention of paying out the CDS. It was all a case of Barnum's Law and the W C Fields Corollary. Look in the mirror, suckers. You've done it again. The whole law of contract has broken down. This is the Age of Obama. Chrysler bond-holders know this full well.

  9. Sam Glionna | March 2, 2012

    When are the dumbed down morons of the world going to finally say 'enough' and revolt, world wide, against the U.N., the Central Banks, and the cancerous, corrupt, greedy, disgusting politicians, governments and bankers across the globe? The harder I look to find a free country with an honest government the more I realize: THERE ARE NONE!

  10. DON COCHRAN | March 2, 2012

    Thx for another great exposition Shah but what happens one day when the players turn on their CDS screens one morning and it says: NO BID.

  11. Ed the Grocer | March 2, 2012

    So what you are saying is 'This might be a lesson well learned". We will end up with much less funny money, less desire for risk and we can spend our money wisely on beer and our time on growing potatoes.

  12. Dr Catsoulis | March 2, 2012

    The world economemy suffers of an incurable cancer. It has already spread(metastasis).Paliative measures are not a cure.Death is around the corner!!

  13. Tom Ervin | March 2, 2012

    Shenanigans. Nobody from now forward will buy or sell a CDS, seems to me.

  14. K. O. Cranston | March 2, 2012

    Unfortunately it appears that the invention of credit default swaps has allowed our financial system to take risks which would never have occured without this "insurance". The world will be far better off in the long run without CDS and the risky behaviour they encourage, but paying the piper is going to be painful indeed.

  15. fallingman | March 2, 2012

    Fabulous article. You do a real service by revealing the pickle the financial "elites" have gotten themselves into. And, in this rare case, it's not us against them…as in slaves against the masters…it's THEM against THEM. Two factions of Masters of the Universe are locked in a Mexican standoff.

    The banks like JPMorgan who sold these CDSs thinking they'd never have to make good on the claims SIT ON THE ISDA COMMITTEE that decides if there's been a default. The people getting screwed by that decision are their financial bretheren. There truly is no honor among thieves.

    Bottom line: SOMEBODY's gonna get hurt here. Either the 5 big banks who sold the CDSs and have to pony up or the hapless chumps who bought that "insurance" thinking it would actually be honored in the event of a default.

    I guess they didn't realize that integrity means nothing anymore. What's so is what the most powerful and well connected SAY is so. The house has burned down and now the insurance company is saying "What fire?" These days, it's all about what you can get away with.

    Every day brings some new development that's more appalling than yesterday's.

    How long can the disintegration continue?

  16. Tzimis | March 2, 2012

    I seriously doubt CDS insurance will survive. Lets see. Who in there right mind wouldn't heavily invest if the risk is taken off the table. The reason why profits exist is because of the risk itself.

  17. Reg Hoover | March 2, 2012

    Shah do you really see a major correction coming.and will you give us enough warning to get out of the way. or may be some shorts to look at. I may have missed some emails but I have not got mutch direction from Capital wave of late. With these mixed messages I am really concerned I value your opinion Please keep the emails coming and may be some suggestions for shorts if you feel or see a correction Thanks for being there for us home gamers

  18. Thomas Hegarty | March 2, 2012

    That's all very well and worse case scenario.
    To make sure the greeks CAN pay some of their debt, is the reason they WILL get the money they need.
    As for those disgusting CDS's going forwards, serves the buggers right, if they don't fancy them in the future.
    It will discourage the greedy from gambling with our collective future !

  19. Kevin Donnelly | March 2, 2012

    Best explanation so far that I have seen.

  20. Charles | March 2, 2012

    Shah's explanation of the Greek bailout and the whole credit default swap mess provides the clearest insight into this situation that I have read to date. He is terrific at breaking things down for the lay person. Kudos! In my view, he is one of the best analysts and writers anywhere, maybe even THE best.

  21. SimonP | March 2, 2012

    Great summary of an impossible situation

    Following this line of reasoning, if my car gets crushed down to a cube, the insurance company doesn't need to pay me because I've still got all the parts, albeit not working quite as well as they used to.

    Lets face it, AIG or no AIG, no-one in the world has enough money to pay the CDS holders when Greece and the rest of Europe go belly up

  22. Martin | March 2, 2012

    Fantastic article, thank you! Meanwhile many of the ordinary people of Greece are starving on less than 300 euros a month and it's only getting worse and worse. Some Germans are beginning to see that Greece needs a Marshall Plan, not a Treaty of Versailles, but will they act in time? I am in Greece now and the atmosphere is highly despondent. Was the Weimar Republic like this? Is there an Adolf in the wings?

  23. miguel samudio | March 2, 2012

    A very interesting article. Thanks!
    In my opinion the ISDA Commitee decision not to declare this event a default, will contribute to the demise of the EURO. Now, who is going to want to buy Sovereign Bonds if the buyer cannot buy insurance? Who would buy bonds where the covenants could be changed sometime in the future at the issuers convenience. – Excluding the ones held by the ECB, of course.

    I wouldn't be surprised if sometime in the near future Portugal, Spain, Ireland and Italy would now do the same with their outstanding sovereign bonds. Change the Bonds without having to ask for bailout funds. Why not. If Greece was allowed, why woudn't they be allowed.

  24. Peter Morris | March 2, 2012

    The financial world is completely out of control, corrupt, and destroying itself and everything else out of sheer greed and compulsion for more money at any cost. They really should all be in jail but siince they own the law they will simply crash the whole system like advanced cancer. The printing presses and lies are flying ever faster and wider like an engine racing faster and faster burning up the oil and then itself. The best thing to do is get out of the way, invest in real things, have a little farm and get ready to start over.

  25. leroy loveland | March 3, 2012

    Thank you for this very informative article.

  26. Tony | March 3, 2012

    Shah
    A brilliant explanation.Act II should be interesting.
    Regards

  27. Pieter Stek | March 3, 2012

    As usual, Shah Gilani's analysis is impeccable. I would only add that the ECB is not just being clever in order to save its own skin but in order to be able to continue to provide the public good of shoring up the system. This is based on the same reasoning that accords the preferred creditor status to the IMF in its support operations for members suffering from payments imbalances and a shortage of reserves to finance them, and who without such support would be forced into worse contractionary policies (and/or into beggar-my-neighbor policies) than they will suffer anyway.

  28. Tom P. | March 3, 2012

    Sounds like the Trioka has been successful in creating a scenario (for Greece) where the Big Banks come out ok and the private investores get run over. Surely there will be law suits brought by the private investors against whomever it is they can sue, but I suspect that whole mess will take a few years to ferret out.

    In the meantime, I imagine CDS on EU soverign debts will be dumped and the purchasing of new ones will be non-existant. If this is the case, a new hedge will need to be created. What do you think it might be?

    If no new hedge is created, at what interest rate do you think the market will require on future debt issuances from the EU countries?

    There are many issues to work through not the least of which will be the set of new issues in a few month's time as Greece defaults and Spain steps up to the plate for their turn.

    What do you suggest the private investor do now?

  29. stev russell | March 3, 2012

    ireland is just 12 months behind grees in a second bail out;

  30. Jim Ennis | March 3, 2012

    Why are these credit events not just called bankruptcies and reorganization (of debt)? Companies do this commonly. Central banks issue funds, unending, to banks and why not countries who cannot pay their debts? Certainly insurance companies do not have the resources to bailout or cover $100sB monthly when a central bank decides not to cover.

  31. Ed Francisco | March 4, 2012

    The above analysis of the Greek bailout by Shah Gilani is the clearest, most concise I have read. Where as others have covered only one aspect of the complex situation and therefore muddy the water all the more, Shah has put it all together in one brilliant presentation.

  32. Barbara | March 4, 2012

    Would you recommend tacking some money off the table now before Mar 20th?

  33. Carolos | March 5, 2012

    A very interesting point of view in that this crisis addresses a wider problem. Trust is essentially a human feature and if "poisoned" can have detrimental effects in a society where "civilised" behaviour is defined by some as a "predictable" behaviour (that how we manage to interact everyday). Can a contract guarantee that someone will not breach it if it eventually goes against his interests in a dramatic way?
    A couple of years from now someone will make a film out of it; with English subtitles.

  34. Richard Suislaw | March 7, 2012

    Hangings in the town square are about to come into vogue!!!

  35. Lorenza | March 7, 2012

    I have been reading all over the internet that the default was engineered and set before we even were told.
    I,as the majority in Greece,still try to get the clear picture as the official information is still so so so joyful and optimistic.
    Are we,the greek people,defaulting?
    At least we have the right to know and not be left in the dark and find out a bright sunny morning that all our working years were equal to nothing.

    Regards

  36. Kevin Postel | March 7, 2012

    I can see it now, a movie with Michael Douglas and Richard Gere

  37. AA1 | March 12, 2012

    Its the same, and sum up to the same,The inevitable is being postponed, lets loose the cats now and see how many rats will survive
    ,Bailout of debts without any realiseable capital investment that will take care of the debts, sums up to adding up of figures that have no collateral value,

    Asess the real factors, discard the fantasies, put the book rights and let all move on,

    Increasing the figures thru inflationary interest rates wont do nobody good, it brings out the issues of professional investors and investment.

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