Credit Default Swaps Strike Again - This Time Driving Greece to the Brink of Default

Credit default swaps (CDS) gained infamy in the early stages of the financial crisis as the murky derivatives that helped drive the likes of Lehman Bros and Bear Stearns into bankruptcy.

Now, they're back, inspiring panic in the bond market and making it harder for Greece to borrow money.  Already struggling to rein in its out-of-control deficit, credit default swaps could be enough to push the debt-ridden nation into default.

Credit default swaps are credit derivative contracts that let banks and hedge funds place bets on whether or not a company, or in this case a country, will default. The CDS buyer makes periodic payments to the seller, and in return receives a payoff if the underlying financial instrument defaults.

Think of it like this: If Institutional Investor "A" has a $10 million loan to Megacorp, Institutional Investor "B" can agree to cover the credit in that loan. In other words, if Megacorp defaults, "B" has to cover the debt. But "B" collects a small insurance premium for agreeing to cover the loan - a premium it gets to pocket as income.

However, one of the biggest problems with CDS contracts is that their holders have an incentive to push companies into bankruptcy.

"It's like buying fire insurance on your neighbor's house - you create an incentive to burn down the house," Philip Gisdakis, head of credit strategy at UniCredit in Munich, told the New York Times.

Some analysts have argued that short-sellers and CDS players helped drive Lehman Bros. into bankruptcy by driving out the company's investors in a wave of panic and then collecting on their bets. And now they say the same thing is happening with Greece.

The Markit Group of London last year introduced the iTraxx SovX Western Europe index - an index based on CDS that let traders gamble on Greece shortly before the crisis. Critics contend that traders and speculators focus on the index's daily gyrations, and as banks and others rush into these swaps, the cost of insuring Greece's debt rises.

Alarmed by that bearish signal, bond investors then shun Greek bonds, making it harder for the country to borrow.

The end-goal of course would be to drive the nation into a full-scale default and collect.

"The problem with credit default swaps is that they offer a more efficient way to short a company, or a country, for that matter," Money Morning Contributing Editor Martin Hutchinson said in an interview. "To sell a share short, you risk all your capital - there's no limit on how high a share of stock can rise. To buy puts, you deal only in a small market, and most puts are short-dated, so you would have to act quickly. With a CDS, however, you pay only an annual premium that is a small fraction of the principal amount involved, you acquire an asset that typically lasts several years, and you can deal in a market of over $60 billion - enough potential profit for even the greediest hedge fund."

When asked if speculators were deliberately trying to promote panic and drive Greece to default as a means of collecting on their CDS investments, Hutchinson said there was no doubt.

Some of Europe's biggest banks, including Credit Suisse Group AG (NYSE ADR: CS), UBS AG (NYSE: UBS), Societe Generale (OTC: SCGLY), BNP Paribas SA (OTC: BNPQY), and Deutsche Bank AG (NYSE: DB), have been among the biggest buyers of swap insurance, sources told the New York Times.

However, that's also because they have some of the most widespread exposure to Greece. French banks hold $75.4 billion worth of Greek debt, followed by Swiss institutions, at $64 billion, according to the Bank for International Settlements. German banks' exposure stands at $43.2 billion.

Trading in credit-default swaps linked only to Greek debt has also surged, with the overall amount of insurance on Greek debt hitting $85 billion in February, up from $38 billion a year ago, according to the Depository Trust and Clearing Corporation, which tracks swaps trading.

That, in turn, has driven up the cost of insuring Greek debt. The cost of insuring $10 million of Greek bonds rose more than $400,000 in February, up from $282,000 in early January.

Greece has raised just $17.5 billion (13 billion euros) of the $73 billion (53 billion euros) it needs to raise this year. About $30 billion (22 billion euros) worth of bonds mature in March and April, so that amount needs to be raised from the bond market before then.

Standard & Poor's on Wednesday said that it may cut Greece's BBB+ debt rating by the end of March, which would drive borrowing costs even higher. Moody's Corp. (NYSE: MCO) yesterday (Thursday) followed by saying it might reduce the country's A2 grade in a few months.

The warnings caused a drop in global equity markets bringing those betting against Greece closer to victory by default. Still, the Greek government ultimately will determine whether or not the speculators win.

"It really all depends on the Greeks themselves," said Hutchinson. "Those betting against Greece can cause panic, but they can't do much more. Greece is much bigger than a company such as Lehman Bros.; it won't just disappear."

The government has implemented austerity measures, which include freezing civil-service wages, cutting public-sector entitlements by 10% on average, raising fuel taxes, and closing tax loopholes. These measures are intended to save between $11 billion (8 billion euros) and $13.5 billion (10 billion euros), but they also have resulted in social upheaval.

Flights were grounded and schools shuttered across Greece Wednesday, as civil servants and private-sector workers went on a nationwide strike to protest the European Union-backed measures. Police employed tear gas to quell uprisings involving 15,000-25,000 protestors in Athens, The FT reported.

The nation has pledged to reduce its deficit to 8.7% of gross domestic product (GDP) by the end of the year from 12.7% of GDP now.

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