Creditflux Newsletter

More and more people (including some who should know better) have started to give credence to the idea that sovereign credit default swaps are worthless. Their argument is that Greece’s failure to trigger a credit default swap when its bond holders have clearly suffered a loss demonstrates that credit derivatives are a useless hedge against sovereign risk.

This is nonsense. Look at it this way. If you buy a nine-month futures contract because you are worried about a fall in stock prices next year, you know that it does not give you complete peace of mind. The market may crash after 10 months, making your hedge worthless.

There is never a perfect hedge. You have to use whatever offers a reasonable balance of liquidity and proximity to the risk in question.

This is what makes derivatives so utterly different from insurance. As everyone who has ever tried to claim on their holiday insurance knows, insurance is a scam targeted at people who believe they can pay to make risk go away completely.

In fact, insurance simply replaces the original risk with counterparty risk. As one industry executive puts it, the business model of the insurance industry is to sell premiums against disaster and then, if the disaster happens, change address and vanish into the night.

As a digression, a good rule of thumb is to buy insurance only if the government forces you to, or to cover a loss that you cannot remotely afford to pay (and never buy on price: instead, compare reviews on the insurer’s willingness to pay).

Derivatives, on the other hand, do not make wild promises about giving you a good night’s sleep. They simply provide a way to manage risk.

So it is with Greece. Despite the terminology used in the popular press, and the unthinking shorthand of some financial journalists (take note Bloomberg), credit derivatives are not insurance. Anyone who bought credit default swap protection on the Greek sovereign will have seen from a cursory glance at the document that they do not promise to make good a loss.

Rather, a credit default swap is a derivative contract that pays out if one of a set number of reasonably well defined events takes place – regardless of whether or not the counterparty suffers a loss.

To date (and who knows what will have happened by the time you read this), Greece has not triggered a credit event. If it succeeds in cutting its debt sufficiently through a soft restructuring that does not trigger the CDS – and that is still a big “if” – then this will be a headache for those who bought protection. But it is a risk that buyers of protection knew they were taking.

The question over the value of the CDS then becomes one that asks whether, given that European leaders have worked so openly to avoid a CDS trigger, sovereign CDS will ever pay out. Well, there may be a political will to prevent triggers, but good luck to politicians if they think they can make all future sovereign debt reductions “voluntary”. Persuading lenders to forgive 50% or more of a debt is something that only happens consistently in countries governed by a politburo.

European banks resemble an ailing horse that is getting beaten half to death by its owner. Even if the nag follows orders this time, there are only so many times the owner can use this method before the animal either rebels or expires.

And when the banks rebel, voluntary debt exchanges will no longer work and any borrower that is unable to pay its debt will need to default in a way that triggers credit default swaps.