Making a mockery of sovereign CDS

What happens when you get a default that equates to a 50% loss for most investors without triggering default insurance? Massively negative unintended consequences.

Europe has just made a mockery of the sovereign credit default swap (CDS) market by trying to structure a default via voluntary 50% haircuts in order to avoid triggering CDS claims. It makes absolutely no sense to act as if Greece is not defaulting here.

As I wrote earlier today:

In Greece, I find it odd that private sector creditors are invited to write down notional debt while the European Central Bank and the Troika are not. Clearly, the voluntary and private sector nature of this structure is necessary to at once avoid triggering credit default swaps, to assuage voter anxiety about taxpayer losses outside of Greece, and to protect the ECB from an explicit loss of capital which would render it technically insolvent.

All of these are legitimate aims. But the optics of this are poor and I am not at all convinced participation in the voluntary arrangement will be adequate to cut the debt burden enough to prevent a further ‘haircut’ down the line.

Bottom line: It’s a sham. And it will lead to either much higher bond yields or massive litigation or both. Choose your poison.

Reggie Middleton was on RT discussing this very issue. He has some very astute commentary. Take a look.

Also see: Greece Debt Swaps’ Failure to Trigger Casts Doubt on Market – Bloomberg

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About Edward Harrison

I am a banking and finance specialist at the economic consultancy Global Macro Advisors. Previously, I worked at Deutsche Bank, Bain, the Corporate Executive Board and Yahoo. I have a BA in Economics from Dartmouth College and an MBA in Finance from Columbia University. As to ideology, I would call myself a libertarian realist - believer in the primacy of markets over a statist approach. However, I am no ideologue who believes that markets can solve all problems. Having lived in a lot of different places, I tend to take a global approach to economics and politics. I started my career as a diplomat in the foreign service and speak German, Dutch, Swedish, Spanish and French as well as English and can read a number of other European languages. I enjoy a good debate on these issues and I hope you enjoy my blogs. Please do sign up for the Email and RSS feeds on my blog pages. Cheers. Edward


  1. Sy Krass

    I ask again, isn’t this going to trigger a bond market collpase soon, more than likely the next weakest link, Portugal?

    1. wunsacon

      Yeah, at least the Americrats print money to pay you 100% nominally on your money.* The Eurocrats won’t print and will defeat your attempts at buying insurance against their default.

      Who will lend money to them?

  2. Lyle

    Since soverign CDS’s are not in any governments interest, this is a way to ban them without explicitly doing so, which IMHO is a good thing. Actually I would ban CDS’s completely as currently structured and make them a pure insurance product regulated and treated as insurance, thus no naked CDS’s to start with, and the seller must reserve from day 1 against a loss just like insurance. The bond market lived for a long time without CDSs and worked just fine. (At least 130 years). They are to much like gambling as currently structured. It just means that if a bank buys a bond it must reserve capital against it using its own judgement. Actually a large part of the current Euro crisis was caused by the low to non existent capital requirements to back sovereign bonds. CDSs should not have been able to reduce capital requirements at all.

    1. Yves Smith

      We’ve made a stronger form argument. Use regulating them as insurance to get rid of them over time. If CDS were adequately margined, no one would buy them. They are an inherently defective product and are destined to keep blowing up guarantors, as they did AIG and the monolines.

      1. psychohistorian

        This is one of those areas that need better “optics” focused on it.

        Repudiating the demands of these “financial instruments” is key to moving forward without either total social breakdown or Rentier slavery.

      2. Jim A

        Doesn’t Reggie’s contention that the intrest rates for European government debt would shoot up without them imply that Sovreign CDSs are significantly underpriced?

      3. sgt_doom

        One thousand thanks for that comment, Ms. Smith.

        Truly, the ability to sell for purchase a limitless number of credit default swaps, along with a limitless number of cmoodity future trades aimed at a particular commodity or financial entity, coupled with a limitless number of investors permitted in a single hedge fund, allow for a limitless amount of financial manipulation and speculation.

        And as that recent Commodity Futures Trading Commission study showed, 95% of all commodity futures trade are purely speculative in nature — not hedging!

      4. steelhead23

        No argument from me, but wouldn’t this also likely have unintended consequences. For example, if I were issuing bonds into a market with a huge discount between ratings levels, I would try to game the ratings. Hence, if the ability to hedge lower quality bonds with CDS were to disappear tomorrow, I would expect to see ratings suddenly jump up. After all, its only opinion. All I am saying is that as much as the financial system is intertwined, so too should be regulations and regulatory systems. One cannot fix the derivatives problem without also fixing the ratings problems.

    2. Parvaneh

      CDS should not exist at all. The risk a borrower poses to the lender is – or should be – included in the interest rate that is being charged to that borrower. This way, a lender needs to take care whom he lends money, because he bears the risk.
      CDS together with the ability to securitise the risk allow a lender to off-load the risk of his bad decisions to others – and this is the heart of the issue and at the core of the fraud culture that has been established by Wall Street and that others all over the world are gladly participating in.

    3. Edward Harrison Post author

      CDS in general were called weapons of financial mass destruction for a reason. We see it here.

      I am sympathetic to the concept of neutering them in this way but, as I indicated, doing so will have negative unintended consequences. Moreover, trying to call this a non-default and then having the private sector take a loss voluntarily but the Troika and ECB not really subverts the rule of law. You have to respect existing financial contracts.

      As Yves said, the best way to get rid of CDS is to regulate them tightly. I say ban naked CDS, ban future sovereign CDS and slowly strangle the market until existing contracts expire.

      1. Dan G

        …and this seems to be the crux of the biscuit- the naked short selling aspect of CDS, it is no longer insurance, but assurance of catatrophe waitng to happen.

      2. sgt_doom

        “As Yves said, the best way to get rid of CDS is to regulate them tightly.”

        Yes, and to immediately reinstitute a financial transaction tax.

    4. AllanW

      Couldn’t agree more with this viewpoint. And with Yves’ rationale for it. And with others’ points that this is exactly the sort of financial casino product that needs to be effectively killed (whether by regulation, competition or social shaming). So why is Ed all hurt about the implications of the current Eurozone deal?

      1. AllanW

        Ah! Just seen something from Ed that must have posted as I was writing.

        Please spell out the ‘unintended negative consequences’. Many thanks.

        1. AllanW

          * crickets *

          Looks like the only point was the very weak ‘But but but sanctity of financial contracts …’. So sue. Next.

    5. decora

      “CDSs should not have been able to reduce capital requirements at all.”

      IIRC that was the entire point of creating credit default swaps in the first place (Exxon Valdez, Blythe Masters, JP Morgan, “Fool’s Gold”, Gillian Tett).

      my favorite thing about CDS is the fact that in the 19th century, there was a massive criminally-run gambling ring called “Policy” – as in “insurance policy”. poor people would buy what were, literally, “lottery derivatives” (rechristened as the “numbers racket” in the early 1900s). anyways. You were buying an ‘insurance’ policy that a certain pattern would come up in the lottery, like 4-11-44.

      Essentially, the last people who conflated Gambling with Insurance were the mafia.

  3. Christopher Fay


    country defaults

    cds party can’t pay and defaults

    counter-party lobbies national govt to bail so it can be paid on its cds

    We’ve seen this with AIG FP

  4. Namazu

    Europe has just declared that all creditors are created equal until they decide otherwise. In 2008 the US sent a top Treasury official to China to assure them even the unsecured debt of Fannie and Freddie would be backstopped. Do you think we’ll eventually see a clear impact on Treasury/Bund spreads?

    1. JasonRines

      The financial priests are going to strangle the rape victims of the West. Economically and physically. The pontification on how Americans are reacting to the debt-incline treadmill already tells you all you really need to know. And as for future trade with China, they will now need to consider whom they will be trading with in 2021. Will it financeers or will they just run over their billion people with tanks that can no longer feed themselves and are revolting. Individual national leaders must be like the movie Indiana Jones and ‘choose wisely’ not ‘poorly’.

  5. don

    Do I understand this correctly, that (non-naked) CDS buyers such as pension funds, will take the loss on Greek bonds and take a second loss on the CDS they purchased, lets say from GS, who by the way sits on the board of the governing body that says that because the banks are voluntarily taking a loss of 50%, which we all know of course that it isn’t voluntary, but no matter, what matters is that it is said to be voluntary, thus said pension fund doesn’t get compensated for insured losses that GS would otherwise pay out to them, but GS nonetheless gets to just keep the fee paid to them by the pension fund since the non-voluntary voluntary loss signifies a non-default default?

    1. Typing Monkey

      Yes, but as others have pointed out, I don’t think that any court (or unbiased arbitration) ruling could ever conclude that this is truly voluntary. I don’t know how this plays out.

      1. Lyle

        But of course the arbitrator is the big banks thru the ISDA, and the governments of the EU can put the screws to them to get the results the government wishes.

    2. Maximilien

      @don: I understand the point you are making, but your scenario is wildly hypothetical. You hypothesize a pension fund and Goldman Sachs as counterparties to a CDS deal—with the pension fund as BUYER and Goldman as SELLER.

      I don’t think this would EVER happen in real life. Pension funds are too stupid or ignorant to buy CDS’s (even if they’re able to) and Goldman is presumably too smart to sell them.

      Buying a CDS can be incredibly lucrative. Selling one can be disastrous (think: AIG). There’s no way GS is going to set up some pigeon pension fund for the score of a lifetime. GS doesn’t feed the pigeons—it plucks them.

      1. aet

        We’ll need to wait until somebody somewhere has a justiciable case – and tries to can convince a Court, somewhere, which has Jurisdiction, such that that Court can undo this deal amongst Governments.

        My own feeling is that the people who cut this deal had lawyers with them.

        And so, my guess is the lawyer bringing any such case to “undo” this deal, or to get damages for its undertaking, would want to be paid in advance.

        1. Gary Anderson

          Well, history shows that homeowners have had little success battling toxic lending in court. They had a little more success in some states battling phony foreclosure documents.

          I wonder if the FDIC would pay on the derivatives parked at BAC?

          1. mk

            BofA Derivatives $75 Trillion

            Global GDP $62.9 T
            US GDP $14.5 T
            Did BofA move all $75 T to FDIC?

      2. aet

        Why would pension funds be making investments in foreign-denominated securities, which investments themselves reasonably needed to be insured?

        Seems to me that any such investment would be imprudent for pension-fund ab initio, and ought not to be undertaken – if not forbidden outright by Regulation.

        As for the domestic Greek pension funds, well that’s another matter.

        Why are fiduciaries gambling with the pension funds entrusted to them , at all?

        Why would they need “insurance” on their investments, unless such investments were imprudent – that is, risky – to begin with?

        Again, why are fiduciaries allowed to gamble at all with the pension funds entrusted to them?

          1. JasonRines

            Ha! I must be a good Fortune Teller after all. I knew someone would say something so ignorant that Skippy’s alter ego would be destroyed. Delicious.

          2. Skippy

            You could speak directly to aet and myself or better, expand on the underlying portent of “ignorant”? Such a throwaway reductionist adjective Jason, zero whit, completely ambiguous, implied meaning with out substantiation.

            Why such an oblique dismissive Jason, too much effort, reduce rebuttal profile, why such a sore spot?

            Skippy…here let me show you how its done, with your own words…

            “Ha! I must be a good Fortune Teller after all.” — JasonRines.

            Me here… I could not_agree_with you more Jason. The status of Fortune Teller is befitting, the art of divining the future via interfacing with inanimate objects and delivered to the malleable (see suckers) with sagely aplomb.

            PS your talents (dimensional managerial concepts) are wasted on the rabble. As the entrepreneur Par Excellence and the Patriot you are, may I humbly suggest, you give the boys a hand in the Stans? I’m sure they would appreciate it. Pssst…zero bid contracts, payed holidays in Paris (blow and executive hookers inclusive) , usa usa usa!

        1. d cortex

          Here in NY State, we had some 40 money managers of our state pensions of which more than half were not qualified by law to do the job for NYS for which they were hired! Cuomo when he was AG, prosecuted this. Also, much of NY States investments befor the downturn under Patacki had been made overseas in Sovereign debt… or at least in AIB of Ireland (do they still exist?)

          What a circus

    3. Jim A

      What happens when some creditor declines to “volunteer”? Especially if those bonds are in a trust, they may not be able to. When somebody refuses the haircut, either because they feel contracturaly obligated to do so, or simply because the don’t want to, it’s going to get interesting. Does anybody have any idea what percentage of the Greek sovreign CDSs are naked? Because I’m guessing the LOTS of people were betting on Greek default without buying any Greek debt. I suspect that it is these gamblers that the “voluntary” sham is intended to shaft.

    4. steelhead23

      You know, I would like to think that a pension fund manager would be smart enough not to purchase Greek bonds, but given the rampant boneheadedness displayed on Wall Street, it may be that coupon chasing pension fund managers DID buy Greek doo-doo. If so, they will be whacked. I prefer to imagine a bond portfolio manager at JPM cajoling his pal at BAC who sits on ISDA’s Determinations Committee into honoring the CDS issued by BAC for his bad bets, while a BAC bond fund manager has lunch with his pal over at JPM who also happens to sit on the committee. That is, it is my fervent hope that the majority of issuers and holders are on that committee and they form a nice, symmetrical circular firing-squad. Boys gotta dream.

  6. Hugh

    I agree with the general sentiment that CDS should have been banned after the 2008 meltdown. It shows how absurd things have become. CDS were never anything other than a con. Now European leaders (and as don suggests CDS sellers like GS) with their own agendas have decided to con the con. None of this is to help the public or Greece. It simply favors one group of kleptocrats over another.

    This should come as a surprise to no one. The economic schemes of European political leaders are coming to resemble those of the banks: create a CDO-like EFSF and when that’s not enough leverage it up into a CDO squared. The turnabout would be comical if the stakes weren’t so high.

    1. nonclassical

      “…favors one group of kleptokrats over another”…

      wondering if U.S. “financial sector” is attacking international finance, in order to destabilize=profiteer, boost their own (false) stability..?

      a typical win-win-win set-up…?

  7. Typing Monkey

    BTW, which debt got written off? short term? Long term? everything equally across the board?

  8. PT Barnum

    CDS was obviously fraudulent. So yeah, they didn’t pay cause the super-rich who own them were never supposed to have to pay.

    This is all because “the taint” in Europe is to strong. “The taint” causes “citizens” to imagine their countries exist as something besides a cookie jar for the super-rich. “The taint” has destroyed many countries. I don’t think I need to name them, as their existence is intuitively obvious.

    This foul and corrosive “taint” has caused the governments of Germany and France to be unable to bail out the CDS because they just should. And really they should. Because.

    The super-rich have, naturally and with the typical dignity such august entities have, passed the losses onto the lesser rich because those infected with “the taint” have refused to pay.

    The rich shouldn’t blame their noble, and superior, brothers for this. They should blame those tainted by the thought that national governments are anything but an endless cookie jar for the wealthy.

    The dirty filthy rabble.

    1. Maximilien

      “Europe has just made a mockery of the sovereign credit default swap (CDS) market…..”

      Great. Now maybe that market will go away for good.

      Why does it even exist? Because the markets for sovereign debt are not big or liquid enough? Or because bankers wanted to add another (unregulated) game to their expanding casino?

      Hmm…..let me guess.

      1. Jim A

        This. Clasically, insurance is for risks that are unlikely to happen, large enough to break you, but small enough that they an insurance company can aggregate the risks over a large number of possible occurances that IT won’t go bankrupt. These are not insurance, they’re simply gambling.

  9. Fiver

    They had plenty of time to set this up and clear it up and down the line inside and outside Europe. Do you see anyone thumping the table screaming? No. Do you see any massive liquidation to pay back the nominal costs of “protection” anywhere? No. How many people were actually betting AGAINST a deal to begin with? Not nearly what was claimed, which ought not to surprise in this “managed market as policy club” environment.

    Just like the whole idea that nobody knew where all the CDS were even when banks clearly did and governments merely had to ask, or who were counter-parties and for how much, thus all the doomsday warnings of another Lehman, there is an assumption that everyone involved – all the top finance people in Europe and the US – is an idiot, and that nobody took steps to cover against major curve balls.

    The outcome remains the same in any case – Europe has been skewered by a Fed that supplied virtually unlimited firepower to predatory currency speculators in the full knowledge they would attack the weakest in Europe, leaving Germany with the choice between cutting Greece loose and containing the damage, but risking a smaller EZ, or saving the EZ by cutting off their own heads. They opted for 2, as there’s now no way this won’t end except via a massive ECB money print ALSO into the hands of the world’s most loathsome people to savage others.

    US launched a financial war and won hands down. European money is going to pour into other markets, much of it to the US. Europe is relegated to sub-global player status. US now has the strategic base laid for a final bubble.

    I hope it’s at least in something that more utility value than a McMansion or 3D I-phones or what I was expecting to start in 2009 – a bubble of “bullshit Green” – all aimed at achieving various “efficiencies” but in reality promising the world’s most wasteful consumers we don’t have to fundamentally change our behaviour at all, when that is in fact precisely what is required. We’ve already had bubbles in stocks, housing and commodities. “Security” industries and health care show no sign of fatigue, but also not enough up-side for a bubble. Pick something really stupid – there’s your winner.

    1. aet

      Those bubbles imho occur precisely to the extent that those goods, which are actually consumer goods in the way they are typically used, are mistaken by people as being capital goods; like residential real estate, gold, computers. There is usually some aspect of the item which CAN be used as a capital good, as a means of further (re-)production – but nevertheless, the item itself, as it is used by and for the vast majority of the holders, is NOT so used as capital, but merely as a store of value for the holder – in the holder’s eyes, gazing on hopefully on her possession – an (ever-) increasing store of value.

      The object of the bubble – be it tulips, houses, or gold – is ALWAYS less useful, less valuable, than people think. Or of less value than the price which people willingly have once paid for them in the past.

      Has there ever been a “bubble” in purely capital goods?

      1. Fiver

        China has more idle cement capacity than the rest of the world has in use. Similar in steel and others. They have gargantuan stockpiles of raw materials. You’re of course aware of the whole “ghost cities” phenomenon. Their error is precisely to have taken “build it and they will come” captial goods investment to the wildest of extremes.

        It was and is a huge mistake. China needed to build a 21st century economy, not one modeled on late 20th century North America and its unsustainable level of urbanization.

        1. Mark P.

          And yet highly-concentrated cities are more energy-efficient and less destructive of the larger terrestrial environment than pretty much any other human habitation arrangement, overall. Half of the world’s population lives in cities today, thereby occupying only 2.5 percent of the Earth’s land surface.

          Conversely, the Kunstlerian/Jeffersonian/ 1960s’ ‘back-to-the-land’ dream of 19th style agrarianism and small towns is environmentally consumptive and non-feasible without 19th century population levels. If you did have those population levels, then you’d have had the corresponding dieback. Thence, you’d have other problems, such that you’d almost certainly be concentrating your resources in urban centers — because, again, cities are far more efficient.

          So urbanization is probably a large part of the future. Though not, I agree, on the 20th century U.S. model of urban sprawl, which is

          1. Roland

            After a certain point, depending on the geography and technologies involved, a large city suffers from an overall diseconomy of scale.

            A large dense city choked with automobiles is not efficient. The waste of time, energy, and human effort in most contemporary cities represents a mind-boggling waste.

            Most of today’s cities are inefficient megalopoles, rather than true, integral, cities.

          2. Nathanael

            Well, sure, automobiles are an inefficient use of space. And roads are an inefficient use of space. Which is why proper cities have urban rail after they hit a certain size.

    2. nonclassical

      ..hmmmnn..military-industrial-complex is secretly performing
      highest tech, most expensive ops in world history-weaponry
      tied to surveillance in space…(which is where MIC $$$$ are
      really going…)

      (all tied into policing auspices)

  10. Robert Callaghan

    Investors are stupider than i thought
    Investment managers are not smart as i thought
    soon black will be white and white will be black
    non-payment leads to turmoil at the very least
    optimism and delusion feed off each other
    only when they hit bottom will junkies seek real help
    we should start a financial harm reduction program

  11. craazyman

    was that TV host wearing a bikini? sure looked that way.

    and how about that camera work, peering under the table and going in and out, what is this Sports Illustrated’s swimsuit photo shoot?

    Yes I had also wondered what the Greek CDS holders must be thinking now. Probably lots of x-rated angry words. What good are lawyers when words mean whatever the power wants them to.

    1. Lyle

      Given that the world handled defaults in sovereign debt for at least 150 years before the “great innovation of the CDS” the world will survive. Yes perhaps interest rates will reflect the true risk all the time, rather than in a crisis. Yes some countries will be unable to borrow as much as well.
      Higher interest rates for more risks are the time honored solution to the problem of risk. Lets go back to that.

  12. yoganmahew

    “Since soverign CDS’s are not in any governments interest”
    I’m not sure this is true – certainly naked CDS are not in any government’s interest, even the liquidity arguments for them appear overstated, so they are probably only in the interest of the buyer (fat tail and all as they are).

    Soverign CDS for purchases of sovereign bonds, however, act to suppress yields. In this, they are hugely in the interest of sovereigns from the narrow perspective of issuing debt, even if they are not from the perspective of maintaining financial stability (again the fat tail risks of temporary lower yields versus the costs of systemic crises).

    The problem with the solution that has been proposed is that not only is the ‘voluntary’ haircut large, but by gaming CDS they have been rendered worthless. There will be no market for peripheral debt that is not insured by the EFSF. Even larger debt markets are likely to suffer.

    With their very cunning plan, the Baldricks at the EU have guaranteed higher sovereign yields and increased usage of the limited supply of the EFSF.

    Finally, with the decline of CDS on sovereigns, a valuable indicator of sovereign stress has been removed. The CDS market has been ahead of the ratings agencies in pricing the woes of sovereigns. It is not perfect, but it is a ‘rating’ system where the seller of protection has money at stake and so has an incentive to get their assessments of sovereigns right.

    That the ratings agencies are gameable and the CDS market is not (both to some degree) may be the underlying reason that the Baldricks want to see an end to it. They might be tired of the underpants and the pencils.

  13. yoganmahew

    How embarrassing – just listened to Mr. Middleton and I appear to be parrotting him in advance…

    1. yoganmahew

      Thanks for the link to your post.

      It rather looks like CDS (at least sovereign CDS) have just died a death…

  14. Oy

    I’ve often wondered why anyone would bother buying a CDS for ExxonMobil and yet they do. What is the point unless they are buying it naked as a Black Swan speculation? Is this a useful use of capital? I don’t think so.

  15. skippy

    PIIGS in a poke[?], the unknowable described by shite mathematics, yet how much dough was made, before some one looked in side (did someone not tell everyone to not slam the oven shut!)?

    Skippy…Bruce tells me it was made in the USA!

  16. Markar

    I would guess this move threw more than a few large European banks under the bus. They are the largest holders of Greek sovereign debt and also bought the protection on it. Now, they not only can’t collect on the insurancCDS they bought, but interest rates on their bond holdings will skyrocket.

  17. Susan the other

    If the 50% was voluntary, then why would there be litigation as Reggie anticipates? Don’t get that part. Was he just worrying about how this haircut basically destroys the once-happy bond market with a level of angst that will cause interest rates to rise regardless of the volunteerism?

    Does the European Stability Fund now function as insurance against defaults? So the taxpayer? Or are they going to shuffle money from surplus to deficit members so things never get so out of hand in the first place? By what mechanism. Volunteerism? If countries do participate in a balancing act it would make crazy financial vehicles like CDS unnecessary. Interesting.

    Sarkozy is saying Greece never should have joined the EU because its economy was not good at the time. A direct swipe at GS and their currency swap deal with Greece? Sarko was also very blunt with Cameron who was dispensing unwanted advice.

    1. No Know

      Forgive me, but I don’t understand what they mean by “voluntary”. Everyone seems to agree that there are CDS “insurance policies” written on several times the amount of debt. So, OK, the nominal creditor can agree to voluntarily write down the debt (which to me implies that they will also voluntarily not attempt to cash in their own CDS “insurance”). But how do they get the holders of naked CDS to voluntarily agree to anything? Sounds to me that in many cases very few people even know who they are. What am I missing here?

  18. mk

    Reggie Middleton said BofA bought Countrywide “voluntarily” as if the government somehow made BofA do it.

    Is that right? Anyone know?

    1. Brett

      It’s not true. That was Ken Lewis’ great idea — he really wanted to buy it and went in and scooped it up as it was failing without any government help or assistance. He did not understand the Countrywide business model (which was built on making fraudulent loans and selling them off to be securitized, the more the merrier), and he vastly overpaid for a company that was greatly insolvent and continues to act like a cancer killing BAC.

      Merrill Lynch acquisition was also Ken Lewis’ idea, though he did get cold feet near the end of the deal when he discovered that Merrill was losing much more money than originally reported (this is his story, John Thain claims that they kept BAC well informed of their giant (and increasing) losses as the merger was being finalized). When he got cold feet and wanted to break off the deal (citing a material adverse change, or MOA) because of much larger losses than he originally thought Merrill would have for the quarter/year. Henry Paulson basically told Lewis that the government would fire him and replace top management if he tried to back away from the Merrill deal, as they were trying all sorts of shotgun weddings to stabilize the markets at the time.

      Many people believe that Lewis had no legal ability to cite an MOA and break off the deal because the deal was written specifically to exclude market moves as a reason to back out of the deal (the CDOs on Merrill’s books during this time were rapidly declining in value as the market was basically frozen and very few bonds were trading, thus causing huge losses for Merrill and many other firms).

  19. Bernd

    Isn´t the fact of having the question whether the default was voluntary or not tied up in the courts for a couple of month or years a positive feature of the whole european deal?
    I thought one of the main problems with the CDS was the danger of them potentially triggering a crisis, which would have to be resolved overnight(/over a weekend).
    The way it looks now, some counterparties will sue, some may win, some may loose, most likely the vast majority of disputes will be resolved via settlements. This will likely drag out over months at least, making it much easier to prevent any systemically relevant contagation.
    In summary: the Europeans have pretty much killed the market for any new CDS and extended the period for the resolution of the existing ones from overnight to at least a couple of months. That seems like good news on both fronts, I don´t get what Reggie is getting all worked up about.

  20. Glen

    I just signed a derivatives contract with my neighbor betting a trillion bucks that Greece will not default.

    I look forward to receiving my bailout check from Timmy G.

  21. vlade

    On no non nein.. It’s not that the sovereign CDS market is being mocked, it’s being nationalised. EFSF is the only one who can issue them (for Europe, anyways)…

    Of course, if you believe that those CDSes (sorry, “guarantees” recently agreed) are going to be any better than the bank written ones, I’ve got a luuuvely bridge guv!

  22. list

    CDS provides useful market information.
    In theory when people model CDS spread they first of all reduce ‘stochastic’ cash flows to its expected values. Doing so they immediately cut off market risk. All like to talk about market risk but it is the pre-requirement of the valuation.
    Other drawback of CDS is that the existing valuation models could not separate illiquidity from credit risk.
    The macroeconomics of the derivatives market if instruments admit settlement in cash is that they call for printing money the action that press and destabilized real economy: food , homes , cars, etc

  23. hugh

    You know you are near the end game when the thievs start stealing form each other. When the elites start bickering over a diminishing pile of spoils that is usually a sign that a major political breakdown, social turmoil and possibly even war is on the way.

  24. Uberdave

    RM is wrong on almost every count with respect to the CDS markets and ISDA, as well as his claims on the effect on the bond market.

    Do your homework, kids!

  25. Nathanael

    Why are CDSs legal? They are either unregulated insurance (illegal) or unregulated gambling (illegal). In particular, many of them run afoul of the ancient common law rule which prohibits “insuring” against an event which you can cause, unless you have good reason to avoid that event.

    In the US, Phil Gramm made them “legal” by passing a criminal piece of legislation, the CFMA, which purported to override all state regulation in favor of no regulation at all. I doubt that this law is constitutional as it seems to violate the 9th and 10th amendments.

    Why the hell are they considered legal in any OTHER country?

    And why haven’t national legislatures simply banned them, declaring them contracts against public policy, which the courts will refuse to enforce? This would be trivial to do. They *are* contracts against public policy.

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