House of Cards: Greek Bond Restructuring, Credit Default Swaps, and U.S. Exposure

Sources

Bloomberg: Credit Default Swaps in U.S. Rise on Greek Debt Crisis Concern

Bloomberg: Greek Debt Wrangle May Pull Default Trigger

Spiegel: Greece's Worsening Situation to Dominate Summit

Spiegel: Hedge Funds Bet on Profits From Greek Debt Talks

The Street: Goldman Sachs Fears Massive European Bank Run

As negotiations to restructure Greece’s debt continue, mounting fears at U.S. banks and financial institutions have prompted significant activity in the credit default swap (CDS) markets. Many U.S. financial institutions have sold CDSs on Greek debt and could face huge payment obligations if Greece defaults. CDSs are essentially bets on the likelihood of default of a given bond issuer. Investors use CDSs to hedge, speculate, or reduce losses on their bond holdings that run the risk of default. The CDS buyer essentially receives full protection on his or her investment because the CDS seller promises to pay the buyer the full amount of the buyer’s investment in the event of default. The CDS buyer pays a fee to the seller to purchase the CDS on a particular bond. Currently, the cost of a CDS on Greek debt is extremely high because of the high likelihood of default.

In an effort to avoid default, Greek bond holders, including private creditors, banks, insurers, and hedge funds, have been negotiating an orderly debt restructuring with the Greek government. Greece must successfully restructure its debt as a condition for securing the €130 billion bailout package from the International Monetary Fund and European Union that was announced last October. Pursuant to initial negotiations, Greek bondholders were expected to take a fifty percent haircut (voluntarily give up fifty percent of their claims) among other provisions, however, negotiations have stalled. Due to the lack of progress on the Greek restructuring negotiations, financial institutions that sold CDSs (that is, guaranteed Greek bonds) are becoming increasingly concerned that Greece may default on its debt, which would trigger massive payment obligations.

This risk is magnified by the fact that hedge funds are taking the other side of this bet. Of the €200 billion of outstanding Greek bonds, it is estimated that hedge funds own €70 billion. While Eurozone finance ministers and the IMF are pressuring investors to accept greater losses, hedge funds that have purchased CDSs on Greek debt stand to profit from the failure of the negotiations. Many hedge funds have employed a controversial investment strategy using CDSs where they are assured profits if Greece defaults and possibly even if it remains solvent. For example, because Greek bonds are trading so cheaply, investors can purchase Greek debt with a face value of €100 million at a significant discount, say €30 million. By purchasing CDSs (which cost less than the bonds) on the same bonds, the investor stands to recoup €100 million on a €30 million investment (plus the cost of the CDS) in the event of a default. If Greece does not default, the value of Greek bonds will likely increase and hedge funds would profit on the bonds they hold. However the cost of the CDS will be a total loss thereby reducing or wiping out any profit. Thus, these investors have no incentive for the restructuring negotiations to be successful and stand to make large profits if Greece defaults. Although this example is highly simplified, it shows the complexity of the situation and the continuing problems complex financial instruments can create when used for speculative purposes.

Although most central bankers and analysts are fairly confident major U.S. financial institutions will not face massive losses if Greece defaults, they cannot be certain. Despite the harsh lessons of the U.S. financial crisis, it appears many U.S. financial institutions have significant exposure to the Greek debt crisis in the form of CDSs. Three years after the U.S. financial crisis, the CDS market still lacks transparency. Thus, Wall Street banks, financial institutions, investors, and regulators all find themselves watching nervously from the sidelines as negotiations regarding the restructuring of Greek debt continue. Ultimately, the culprit in the potential downfall of the Greek negotiations and cause of significant losses for U.S. financial institutions may be the same one that played a major role in the U.S. financial crisis three years ago–the CDS.