On Greek CDS

I am quite a strong advocate of the most recent European bailout package. However, there is one aspect of it which I cannot countenance: European policy makers' pathological obsession with avoiding triggering Greek CDS.

By keeping the 50% writedown of privately held Greek debt strictly voluntary, it appears that this absurd fixation will be satisfied - the ISDA has indicated that they will not consider this a credit event. Beyond 'punishing the evil speculators', I am struggling to figure out why this issue is a focus of the Eurocrats.

I have detailed DTCC's numbers for the net notional exposures outstanding to various European countries (here), and they have fallen further (to $3.67 billion) since that post. Compared to the size of the 'voluntary writedowns', this is peanuts, so these exposures are not the motivation. I suppose it is a possibility that there is a huge over-the-counter exposure (ie not accounted for in DTCC's figures) held by some sort of European AIG, but I cannot imagine this is the case, as who would purchase non-standardized contracts if they had the choice of their centrally cleared counterparts?

The hushed-up incident of the suppressed European Commission policy paper which indicated that CDS provided liquidity to sovereign debt markets (here) erased any credibility policy makers had, leaving me to assume that it is in fact as simple as 'punishing the evil speculators'.  That is insane. What about the (presumably stupid) speculators who took the long side of these contracts when Greece was clearly bankrupt? Shouldn't they be punished? Or, what if the long side recognized Greece's insolvency but placed a bet that any bailout package would not include a CDS trigger - for some reason I find that deeply unsettling.

More important than the motivation are the ramifications, and with some guidance from Macro Man (here) and FTAlphaville (here), I have isolated what I consider to be the three most significant implications:

1. This will spell the end of the sovereign CDS market. When a 50% haircut doesn't trigger payout, then who will trust these credit products moving forward? Macro Man has suggested long-term bond futures as a viable alternative to CDS for hedging purposes.
2. If sovereign CDS cannot be trusted as a hedge, any holders of peripheral sovereign debt who had hedged via CDS will now be second-guessing the safety of their positions and will be incented to sell their remaining peripheral sovereign debt holdings, thereby pressuring funding costs for these countries.
3. What will this mean for the capital positions of banks which have hedged positions via CDS? Basel II gave relief on capital requirements positions hedged with CDS, but if the hedges are now (arbitrarily) bunk, this becomes a serious question. 

And that is only what immediately comes to mind; there may be more (as yet invisible) implications. The bottom line is that this policy is both populist and reactionary. Those three words in a sentence make me shudder. The thought of financially-illiterate European policy makers attempting to fine-tune financial markets should be reserved for my nightmares.

European Blow-Up Risk - Hedge Edition

If you were looking to hedge European meltdown risk in the CDS market, who would be your reference entity of choice?

Parsing CDCC data gives us an indication of how others are hedging this type of exposure - French CDS. Initially, I found this surprising: if you are worried about your exposure to Italy or Spain, wouldn't it make sense to go long their respective CDS? On second thought though, this move appears quite rational. Assuming that Italy and Spain are too big too bail out (that is certainly the perception on the street), then it is reasonable to assume that if either of their bond markets collapse, the French government would be the next domino. So why pay a higher spread for Italian or Spanish CDS when French CDS provides essentially the same hedge? I think that my interpretation is strengthened by the fact that net notional exposure to France took off in July and August, as Italy teetered on the brink

Another interesting nuance of the data is that CDS exposure to Greece and Portugual have fallen substantially this year. Could it be the case that all those lawyers that the EU have hired to avoid a technical default are undermining market confidence in whether Greek/Portuguese CDS will actually payout in the event of default?