Characteristics and operation of the sovereign debt: the example in Greece

12 July 2012 by Daniel Munevar

At the end of the 90s a division of JP Morgan devised a financial mechanism conceived especially for protecting clients from losses resulting from title defects or other financial instruments Financial instruments Financial instruments include financial securities and financial contracts. which they detained. This instrument, called Credit Default Swap (CDS CDS
Credit Default Swaps
Credit Default Swaps are an insurance that a financial company may purchase to protect itself against non payments.
) has, in less than a decade, gone from being an obscure financial engineering invention to one of today’s favourite large scale speculation tools. Hence the need to understand the operation and the central role of this instrument in the discussions of the crisis of the sovereign debt Sovereign debt Government debts or debts guaranteed by the government. in Europe.

A CDS is insurance on a financial instrument. As in the case of normal insurance, the entity seeking protection for an asset Asset Something belonging to an individual or a business that has value or the power to earn money (FT). The opposite of assets are liabilities, that is the part of the balance sheet reflecting a company’s resources (the capital contributed by the partners, provisions for contingencies and charges, as well as the outstanding debts). (credit or security) commits to making regular payments in return for protection in the event of a default. There is nevertheless a fundamental difference between a CDS and traditional insurance, which requires ownership of the asset for which one is soliciting protection. A person may, for example, take out insurance on a house or a car which s/he owns personally, but not on that of a neighbour. This impossibility impedes the creation of perverse incitement to destroy the property of others. If someone could acquire insurance on the property of another, in this case, on that of their neighbour, it would be in their interest Interest An amount paid in remuneration of an investment or received by a lender. Interest is calculated on the amount of the capital invested or borrowed, the duration of the operation and the rate that has been set. to set the neighbour’s car or house on fire in order to obtain the financial compensation from the insurance. Therefore, this type of result would evidently be undesirable both from an individual and a social point of view.

However, this type of impossibility does not exist in the case of CDS. Any person or entity may acquire and transfer a CDS with no propriety relationship to the credit or the title linked to this financial instrument. This characterisitic of CDS has two consequences. Firstly, the difference between CDS and insurance and traditional financial derivatives Derivatives A family of financial products that includes mainly options, futures, swaps and their combinations, all related to other assets (shares, bonds, raw materials and commodities, interest rates, indices, etc.) from which they are by nature inseparable—options on shares, futures contracts on an index, etc. Their value depends on and is derived from (thus the name) that of these other assets. There are derivatives involving a firm commitment (currency futures, interest-rate or exchange swaps) and derivatives involving a conditional commitment (options, warrants, etc.). permits CDS to evade the regulation of these sectors and converts them into a particularly opaque section on international financial markets. Secondly, the purchase or sale of positions on a financial asset which one does not own facilitates speculation for sums representing several times the value of the asset in question. This can be illlustrated with the collapse of subprimes in the United States. CDS have permitted speculative gambling of billions of dollars on mortgages valued at millions of dollars. Indeed, CDS have permitted a dramatic expansion in speculation on the aforementioned mortgages and have ultimately caused losses due to a slump in their value.

In the face of the slump in this segment of the market and the inherent logic that financial capitalism maintains the growth of compound interests [1] , CDS have started to be widely used in other sectors of financial markets. One of the most dynamic segments after the 2008 crisis was that of CDS in the European Sovereign debt where it is assumed there are brut positions exceeding 100,000 billion dollars. In fact, as mentioned by Michael Lewis in his latest book, Boomerang, it was precisely individuals and institutions who have made a fortune by buying CDS linked to the mortgage Mortgage A loan made against property collateral. There are two sorts of mortgages:
1) the most common form where the property that the loan is used to purchase is used as the collateral;
2) a broader use of property to guarantee any loan: it is sufficient that the borrower possesses and engages the property as collateral.
system in the United States who were the first to acquire significant positions via this same instrument against the sovereign debt of countries in the Euro zone. As with the speculative euphoria in the United States, which is based on the capacity of American households to take on debts beyond their financial means, the recent prosperity of countries like Spain and Ireland came about as a result of the possibility for private and financial sectors of these countries to accumulate these debts that exceed the production of national wealth. In both of these cases the CDS are transformed into tools for these speculators who have capitalised on the unsustainable nature of these models to make fortunes which can be compared with benefitting – in the insurance world – from the destruction of the neighbour’s house.

A useful case for understanding the working of CDS and the problems they cause is the evolution of these instruments linked to the Greek public debt. After the Wall Street collapse in September 2008 there was an unprecedented growth of net positions of CDS on the Greek public debt which, in 2009 increased by more than 2 billion dollars, that is, by more than 35%. It’s important to remember that at that time the euro’s capacity to protect its weakest members from speculative attacks was constantly talked of. The cost of protective cover against defaults of the Greek debt were quite low at that time, costing 10 basis points. The purchase of protection for 100 million euros of Greek debt cost, for the entire period of the contract which is on the 5 year CDS, 10 million euro, which meant 2 million euro per year to maintain the CDS. The entities that entered the market at that moment placed the next bet. Greece could either keep up the payments during the course of the period from 2009-2014 and lose a maximum of 10 million euro, the equivalent of the insurance price. Greece could either go into default or restructure her debt and the profit Profit The positive gain yielded from a company’s activity. Net profit is profit after tax. Distributable profit is the part of the net profit which can be distributed to the shareholders. could be up to 100 million euro, representing the payment of the CDS indemnity equivalent to 1000% of the insured risk.

Faced with the perspective of so much gain it is hardly surprising that the situation changed radically from 2010. The interest rates Interest rates When A lends money to B, B repays the amount lent by A (the capital) as well as a supplementary sum known as interest, so that A has an interest in agreeing to this financial operation. The interest is determined by the interest rate, which may be high or low. To take a very simple example: if A borrows 100 million dollars for 10 years at a fixed interest rate of 5%, the first year he will repay a tenth of the capital initially borrowed (10 million dollars) plus 5% of the capital owed, i.e. 5 million dollars, that is a total of 15 million dollars. In the second year, he will again repay 10% of the capital borrowed, but the 5% now only applies to the remaining 90 million dollars still due, i.e. 4.5 million dollars, or a total of 14.5 million dollars. And so on, until the tenth year when he will repay the last 10 million dollars, plus 5% of that remaining 10 million dollars, i.e. 0.5 million dollars, giving a total of 10.5 million dollars. Over 10 years, the total amount repaid will come to 127.5 million dollars. The repayment of the capital is not usually made in equal instalments. In the initial years, the repayment concerns mainly the interest, and the proportion of capital repaid increases over the years. In this case, if repayments are stopped, the capital still due is higher…

The nominal interest rate is the rate at which the loan is contracted. The real interest rate is the nominal rate reduced by the rate of inflation.
on the Greek debt started to rise considerably when it became evident that resorting to external aid or to restructuring in order to keep their finances afloat was only a matter of time. It was during that period - around June 2010 - that the CDS on the Greek debt started to climb significantly, going from 10 basis points to almost 80 in February 2012. The probability of a default had become much higher than the market agents had previously believed and this affected not only the price of obtaining protection but also the inclination of the financial entities to offer such protection in the form of a CDS. With the increased price of CDS on the Greek debt the net positions started to collapse. From a maximum of 9 billion dollars in November 2009 they went down progressively to 3.1 billion dollars in February 2012. And yet, the two phenomena are linked. Given that the payment default was just a matter of time the insitutions who initially sold the CDS sought to transfer the risk to third parties, or to reach a direct agreement with the initial purchaser of CDS to end the contract with a cash payment, thus reducing the maximum sums payable Payable A sum of money that one person (debtor) or group of people owes to another (creditor). in the event of a default.
The decision of the purchasers of CDS on the Greek debt to end their contracts in exchange for a cash payment rather than wait for the default and thereby maximise their profits associated to the CDS is understandable once it is known that the default in question is probable but not 100% certain. Once negotiations with Troika Troika Troika: IMF, European Commission and European Central Bank, which together impose austerity measures through the conditions tied to loans to countries in difficulty.

began for the loan and for the subsequent restructuring of the debt it was not known if this latter which would reassemble the majority of the creditors could be described as a credit event [2] and therefore activate the CDS. The International Swaps and Derivatives Association ISDA
International Swaps and Derivatives Association
A private entity whose members are banks who deal in derivatives.

International Swaps and Derivatives Association :
(ISDA), the entity responsible for deciding on the activation and the final amount of a CDS compensation, has adopted an ambivalent attitude in this respect, which is causing a great deal of uncertainty. The debate considered the possibility of the European authorities putting pressure on the ISDA and forcing it to declare the restructuring process as being voluntary in order to avoid activating the CDS and thereby reducing the instability of the markets. Faced with the possibility of being left without any profit, a large number of investors with positions in Greek CDS have behaved like professional casino gamblers and have cashed their securities, making agreements with the institutions that had initially sold them these instruments.

Another group of investors with positions in Greek CDS has preferred to double down by acquiring securities for the Greek public debt. Although at first sight this decision may appear unwise given that the CDS represent a bet on the non payment of these debt contracts, in this case the aim was not to make profit but to form a part of the investment group that holds discussions between the Greek government and the private securities holders before the restructuring in mid March.

During the course of these negotiations the CDS holders – unlike other securities holders – has asked the Greek government to reduce to a minimum the payments derived from restructuring. The explanation of this paradoxical situation is simple. The greater the losses of the securities holders the higher the profits derived from the CDS.

The CDS holders who took part in the restructuring negotiations have subsequently become one of the chief obstacles against reaching an agreement to the effect that the restructuring is considered as a credit event. The initial announcement of a restructuring agreement took place on 9 March. Initially 85% of the creditors agreed to exchange their securities for the Greek debt for new ones valued at an equivalent of 53% of the previous ones. This figure of 85% rises to 95% with the use of collective action clauses (CAC) which forced the other group of investors to accept the exchange. The ISDA used the CACs to define the exchange on the same day (9 March) as a credit event and activate the CDS. This declaration has led to the last stage associated with CDS, the calculation of the final amount payable by the entities that sell protection.

Given that the CDS refer to the price of other financial contracts Financial contracts Also referred to as ‘hedging instruments’, they include futures contracts on interest rates, swaps, futures contracts on all merchandise and commodities, options contracts on the purchase or sale of financial instruments and all other futures instruments. such as government debt Government debt The total outstanding debt of the State, local authorities, publicly owned companies and organs of social security. securities, their value depends on what is called the recovery values of these contracts following the declaration of the credit event. This means that following the default a financial contract still has a certain value which depends on a possible law suit on the part of the speculators – most of them vulture funds Vulture funds
Vulture fund
Investment funds who buy, on the secondary markets and at a significant discount, bonds once emitted by countries that are having repayment difficulties, from investors who prefer to cut their losses and take what price they can get in order to unload the risk from their books. The Vulture Funds then pursue the issuing country for the full amount of the debt they have purchased, not hesitating to seek decisions before, usually, British or US courts where the law is favourable to creditors.
- in order to recover part of the amount of the original loan. In the case of company defaults this probability is relatively higher and the recovery is generally between 50 and 70 cents per dollar. In the case of public debt defaults this amount is much lower and generally represents between 10 and 30 cents per dollar. Given that the CDS covers the face value of the debt security, that is, 100 cents per dollar, the final payment of the CDS is the difference between the original face value and the recovery value. For the CDS holders, the less the recovery values are raised and the more the title holders lose, the higher their speculative gains.

The ISDA sets up a bid on the title defects to determine the recovery values and eventually the CDS payments. The curious aspect of these bids is that there are more CDS holders than securities holders. The default securities which are difficult to convert into cash do not therefore circulate very much on the markets, the transactions on the bids market are therefore relatively weak in comparison to the value of the CDS. For Greece the bid took place on 19 March in two stages. During the first stage the default securities holders announced the sale and purchase price at which they were prepared to negotiate for these instruments. During the second stage the participants announced whether or not they were prepared to proceed to the sale or purchase for the prices established during the first stage of the process. During the sale of 19 March the securities sold rose to 291 million euro and the retrieving value was fixed at 21.5 cents. The payment value of CDS at 78.5 cents generated payment obligations for a total of 2.5 million dollars, that is, almost 10 times the value of securities exchanged during the bid, for a total of 3.1 million dollars for net positions of existing CDS. This means that in the case of investors who acquired CDS before June 2010 and who kept their positions until the end, these instruments brought them a profit of …785%! With such staggering profits it is not surprising that CDS have become the perfect tool for large scale financial speculation.

However, the price for this potentially exhorbitant profit from CDS is the risk they pose to the stability of the financial markets. Firstly, by allowing positions representing several times the value of the actual asset that they reference, CDS dramatically raise the losses associated with financial panic. Secondly, CDS and their insurance mechanism create the illusion of reducing risks. But in fact the losses resulting from a default are transferred to the entity that sold the protection in the form of CDS. In other words, the profit from a CDS is directly dependent on the ability of the entities that sell this protection to fulfill their commitments. The AIG demonstrated in 2008 that in the event of financial panic this is not the case. Thirdly, the link between CDS and the declaration of credit events has resulted in fraudulent behaviour which has led to the collapse of the entities or countries to which they are linked.

When all of this is taken into account, CDS should at best be eliminated from the financial markets entirely or at worst be subject to regulation as traditional insurance mechanisms. Such mechanisms would limit CDS to real positions in financial assets. Furthermore they would oblige entities active in the sale of such instruments to increase their reserves significantly in order to be able to cope with losses. As long as measures of this kind are not taken, financial instability can only increase and the destruction of entire countries linked to CDS profits will become commonplace in the financial markets.

Translation Ümit Hussein in collaboration with Christine Pagnoulle.


[1Compound interests are interests that are incorporated into capital and in turn result in interests. This aggregation of interests to capital lead to an exponential increase in the debt. This mechanism is also called anatocisme and is illegal in certain Constitutions, such as the Italian Constitution.

[2An unpaid debt allowing the activation of the CDS

Daniel Munevar

is a post-Keynesian economist from Bogotá, Colombia. From March to July 2015, he worked as an assistant to former Greek Finance Minister Yanis Varoufakis, advising him on fiscal policy and debt sustainability.
Previously, he was an advisor to the Colombian Ministry of Finance. He has also worked at UNCTAD.
He is one of the leading figures in the study of public debt at the international level. He is a researcher at Eurodad.



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