The Greek Debt Crisis: Another Failure of Derivatives

Once again, derivatives have failed. This time, it's in the Greek sovereign debt crisis. Greece and many EU member nations are dead set on making private holders of Greek bonds take losses in the range of 70% of the face value of the bonds. Not only that, but the EU wants to structure the hit to private bondholders in such a way that it doesn't trigger the requirement for credit default swaps (which are insurance on the bonds) to pay injured bond holders. The legalities involved become rather labyrinthine at the margin. Suffice it to say that the entire bucket of yogurt may well end up in court, where attorneys charging very reasonable fees will secure the funds needed for their children's college tuition.

Court isn't where holders of credit default swaps want to be. Even if, after years of litigation, they receive substantial recompense, they are likely to view CDS's as a flop. A derivatives contract is meaningless if it doesn't transfer risk as advertised. And CDS's on Greek sovereign debt are starting to look pretty hinky.

An interesting question is why is the EU so intent on preventing payouts on the CDS's? Possibly, the EU is concerned that the counterparty risk is concentrated in one or a few institutions, where the losses from payouts might be destabilizing. We're also told that we are supposed to be comforted by the fact that the net exposure in the CDS market for Greek bonds is around 3 billion Euros and that CDS exposures are collateralized, so that counterparties shouldn't be caught in a "run" a la AIG 2008. Okay, 3 billion Euros isn't that much for the world financial system as a whole. But what if it's concentrated in one or two or three firms? As for collateral, what quality are we talking about? If the collateral is EU sovereign bonds (a likely possibility), then one would be forgiven for nervousness about undercollateralization.

In addition, the EU may wish to punish the speculators that bought up Greek sovereign debt at substantial discounts to face value and would profit handsomely if they received CDS payouts (which could be as much as 100 cents on the Euro, although technicalities of the calculation of payouts could result in smaller but potentially still profitable payouts). Ever since hedge funds walloped the British pound in 1992, Europeans have had a fear of financial speculators. Whether that's rightly or wrongly so, CDS holders may be suffering as a result.

Whatever the problem may be, the EU's fears of CDS payouts are evident. Surely, this sordid episode will shake up the market for EU sovereign bonds. Liquidity will fall as private investors realize they can't offload the risk of the political dysfunction that's at the heart of the crisis. EU members have criticized the Volcker rule, arguing that it will discourage big U.S. banks from making markets in EU sovereign bonds. These critics, however, should deal with their own botch-ups before foisting blame on American efforts to safeguard depositors' money. The heart of the EU sovereign debt crisis is that Europeans wanted the benefits of a currency union without having an effective mechanism for dealing with the risks. As bond investors come to realize it's difficult to offload political risk via the CDS market, liquidity in EU sovereign bonds will surely diminish. And the fault lies on the eastern side of the Pond.

Blowback on Wall Street from Scott Brown's election in Massachusetts

A problem with blowback is you can't be sure what it will hit. Scott Brown's election as the senator from Massachusetts to replace Ted Kennedy was blowback from the Obama administration's inattentiveness to the independent voters who put it in office. But that election led the administration to cater to those same independents by shifting focus away from health insurance reform and back toward Wall Street.

The big money lobbyists almost pulled it off. A quiet, but determined lobbying effort in the second half of 2009 had persuaded the administration and Congress to slide financial regulatory reform toward the back burner. Most Democratic political capital was committed to reforming health insurance. The Republicans, realizing that the Dems were tied up with Washington problems, set an ambush in Massachusetts. Just as inattentive deer don't survive the time in the fall when a lot of people wearing blaze orange enter the woods, Martha Coakley and the Dems paid the price for not staying alert.

Then, Barack Obama demonstrated why he was elected President. Two days after the debacle, the President announced a proposal to place new restrictions on the activities of big banks designed to prevent them from using federally insured deposits or loans from the Federal Reserve to engage in risky and speculative activities. Remember that last week, the administration proposed a tax that would fall primarily on big banks' short term borrowings (excluding customer deposits), thus discouraging them from using fast money leverage. Taking these two initiatives together, big banks will have powerful incentives to formally split their depositary and investment banking operations. Add the extensive regulation of bank holding companies that exists and the increased holding company regulation that may well be on the way, and you have a regulatory mix that would encourage a complete corporate breakup between depositary banks offering federally insured deposits and the Masters of the Universe who do the wild and woolly stuff.

Yesterday, the political theater was vivid, with Paul Volcker standing next to the President as he announced the proposal to revive, sub silentio, the Glass-Steagel Act. Volcker, a former Chairman of the Federal Reserve and an unyielding proponent of increased prudential regulation for banking, is widely reported to have been in the Democrats' gulag for the past year. It seems that Scott Brown unintentionally got Volcker sprung, and along with him serious intent to crack down on Wall Street.

That wasn't quite what the Republican agents provocateurs assisting Brown intended, either. But they placed their chips on the outrage of independents. Those who live by populist ire die by populist ire. Wall Street stands shoulder to shoulder with the federal government as a target of independents. The President and his aides know this, and they have turned their agenda on a dime to steer the pitchforks toward the big banks. If the Republicans use their 41-vote minority in the Senate to block the new, improved financial regulatory reform proposal, they will find themselves on the wrong side of pickup truck-driving insurgents. It's very unpleasant to be hit by a pickup truck.