Greece and Credit Default Swaps: Bucking the ISDA Cartel

Credit derivatives were originally hyped as hedging tools to protect the value of a portfolio. For example, if you own a bond, you can buy protection against the possibility of default by paying a protection premium, similar to the premium you pay on an insurance policy. The difference between insurance and the credit derivatives known as credit default swaps (CDS) is that you don't actually have to own the bond in order to "buy protection." But like an insurance policy, you have to negotiate the terms of the contract.

Leverage and Language

Since I wrote the first edition of my book, Credit Derivatives and Synthetic Structures in 1998, (John Wiley & Sons, second edition 2001), nothing has changed for the better in the credit derivatives market. It is the first trade book about credit derivatives and stresses that these products are primarily used for leverage. The overwhelming problems are pricing and the risk of misinterpretation of the meaning of the contract language.

Language "Arbitrage"

Sometimes contracts are maliciously written to disadvantage the unwary; this is also called "language arbitrage," because manipulating the language makes a risk-free gain for the perpetrator. In April 2005, I explained to the International Monetary Fund (IMF) that no one in the credit default swap market should trust ISDA "standard" documentation. One has to rewrite the contract language to protect one's own interests. The beginning of this clip illustrates that point:

Janet Tavakoli at the IMF conference, "Asset Securitization and Structured Financde: Benefits, Risks and Regulatory Implications," April 19, 2005 (requires Windows Media Player).

The following is from my March 12, 2010 post, "Washington Must Bank U.S. Credit Derivatives: Games and Gold," on problems with U.S. credit derivatives, but it applies to the problems with credit default swaps on Greece today.

Sovereign Credit Default Swap Contracts: Tower of Babble

The credit default swap market has a history of conflicts, and the worst of them occur when it is time to settle up. For example, hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts Eternity had purchased.

J.P. Morgan's posture was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed the slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.

The problem today is that some owners of credit default protection on Greece think they should be able to declare a credit event, but the ISDA cartel has issued an opinion that according to its interpretation of the documents, there has been no default. The problem has always been that contract language is subject to both abuse and "interpretation."

Greece and the ISDA Cartel: Language Games

There are a variety of problems that arise with credit default swap language. The two biggest are disputes about the definition of a credit event and disputes when it's time to settle up after everyone finally agrees a credit event has occurred. Settlement disputes arise over the value of the physical instrument delivered (for physical settlement) or with the calculation of the cash settlement amount (for cash settlement).

Recently the ISDA committee, which is stacked with the large financial institutions that dominate the trading of these products, ruled that no credit event has yet occurred for holders of credit default protection on Greece, if one used "standard" ISDA documentation.

The committee is controlled by the largest banks and financial institutions that trade these products. You can view the list here. For the Americas, the committee includes Voting Dealers: Bank of America / Merrill Lynch, Barclays, Citibank, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase Bank, N.A., Morgan Stanley, Societe Generale, UBS, and Voting Non-dealers: BlueMountain Capital, Citadel LLC, D.E. Shaw Group, Elliott Management Corporation, and Pacific Investment Management Co., LLC.

Credit Default Swaps: A Speculators Dream of Leverage

Given all the problems for hedgers, why has the credit derivatives market grown like crazy to notional amounts in the tens of trillions of dollars?

Speculators poured into the CDS market because of its tremendous leverage. If you think a bond might go down in value, or if the bond is downgraded, the credit default swap will gain in value, even if no default occurs. A speculator who gets in early enough can exit the trade at a huge profit and is out only the amount of the premiums paid in the meantime.

It's as if you bought a life insurance policy on your sovereign neighbor, known to those paying attention to be a reckless-driver, and then made a killing when your neighbor had a fatal accident. Obviously, you know it wouldn't be fair play to tamper with your neighbor's brakes, but others who stand to make a huge gain might be tempted.

Speculators look for huge swings in value. Some speculators aren't too fussy about how those swings in value occur and sometimes try to help it along by say, stoking a rumor mill or other market machinations.

Since credit derivatives often allow speculators to get the benefit of high leverage for very little initial outlay, credit derivatives, which were once touted as hedging tools, have become dominated by speculators.

Pricing is Always an Issue: You Can't Trade With a Screen

If a speculator bought credit default protection on Greece a couple of years ago, the speculator wouldn't have paid much in premiums and today can make many times the initial outlay. For example, during the past couple of years (depending on when one entered and exited) a few hundred thousand dollars could net a gain of several million on a $10 million trade.

But the trade is for people with deep pockets, because the pricing is controlled by a handful of traders, and when you ask for a price, the screen price becomes irrelevant and all of the "market makers" suddenly offer you the same lousy price. In one recent example, a speculator with a $10 million notional CDS claimed that he was being ripped off for $500 thousand after being low-balled in a bid for the protection he had purchased long ago. That $500 thousand isn't merely 5 percent of the notional amount, since it represents a much larger percentage of the gains to which he believed he was entitled. This sort of thing happens all the time, since pricing is controlled by a small group of market makers who often have a buyer lined up on the other side. Any money the "market maker" middleman squeezes out of buyers and sellers becomes profit.

Speculators aren't as fussy about language, because unlike hedgers, they aren't trying to match off risk. Often the interests of speculators and hedgers are misaligned, since hedgers often prefer that the underlying bonds (or other risk) recovers -- the risk is rarely completely hedged, because hedges are expensive. But speculators often make a naked bet. If a speculator is long credit default protection, the worse things get, the more the speculator makes.

Protect Yourself

There are so many issues in the credit derivatives market, that it's impossible to cover them all in a post. The Dodd Frank Act won't resolve the problems in the credit derivatives market, and bank lobbyists were successful in neutering effective change.

The disputes over credit default swaps on Greece highlight the fact that most participants in the credit derivatives market are at the mercy of ISDA when it comes to interpretation of ISDA's language. The only solution to that is to exercise one's rights, and insist on a custom-made over-the-counter contract that protects one's interests. As the past few years have shown, "regulators" won't protect investors either before or after the fact. You have to protect yourself.

Credit Dervatives and Systemic Risk

In earlier commentaries, I discussed how credit derivatives foster systemic risk in the global financial system. One example is "Goldman's Undisclosed Role in AIG's Distress," Nov. 10, 2009.

Endnote: My new e-book, The New Robber Barons, is now available in the U.S., UK, Germany, France, Italy, and Spain.

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