Some Thoughts on the CDS Market and Greek Developments

There is much truth to the generalization that European banks took on direct exposure to European sovereigns through the bond market, while top banks took exposure through selling insurance, primarily CDS, on the sovereigns. The latest BIS data suggest that in H1 2011, US banks increased their CDS sales by almost $81 bln to $518 bln. Two thirds are tied Greece, Ireland, Portugal, Italy and Spain. Five US banks count for more than 90% of the CDS exposure (JP Morgan, Morgan Stanley, Goldman Sachs, Bank of America and Citi, according to a report by the US government.

US banks also use CDS to hedge exposures to sovereigns as well as counter-parties. The late June BIS report showed that US banks have directly lent about $181 bln to these five European countries and have nearly 3 times more CDS coverage. When US holdings of CDS are taken into account, US exposure (total risk) rises to $767 bln, according to the BIS.

Reports suggest that the increase in CDS sold by US banks in H1 2011 appears to be filling in a vacuum created by the reduced exposure of German and UK banks to Greece, Portugal, Ireland and Spain. On the other hand, US banks increased the CDS sold on Italy, but German and UK exposure to Italy did not decline.

ISDA decides whether an event trigger the default clause in the CDS agreements. The key committee within ISDA that makes the determination is composed of 10 people from banks and five investment managers. A decision requires 12 of the 15 votes. ISDA said on Oct 27 that the agreement would most likely not be considered a default.

We argued that opposition and finance minister's call for a super majority of parliament to approve the European deal risked toppling the government. The referendum call was a way around that risk, but catches on the other horn of the dilemma in the sense that a majority of Greece, according to the weekend polls) no not support the agreement.

Moreover, it is becoming less clear that the government will survive the vote of confidence slated for Friday. Previously the PASOK government had a three seat majority in the 300 seat chamber. Recent news reports suggest that majority is down to a single vote.

A collapse of the government or a rejection of the referendum, if it comes to that, risk a harder and less organized restructuring that could be trigger the sovereign credit default swaps after all. Uncertainty and fear is palpable and although it is easy to blame the Greek government for this political gamble, we have consistently highlighted the fragility of the government. The political fragility extends throughout other periphery.

Greece is the only country of the three aid recipients that have not changed governments. Spain is likely to change governments later this month and Italy's government seems as if it could collapse any day as well. The political cost of the economic austerity does not appear fully appreciated policy makers or investors.