1. News Articles
  2. Related News Articles
News Article Details

Default Insurance Market Takes Hit

Source: WSJ - Serena Ng & Katy Burne

Posted on 28 Oct 2011

Facebook LinkedIn Twitter Google

A vast market in which banks, hedge funds and investors trade insurance against debt defaults got a jolt Thursday, sparking worries of new strains in the global financial system.

Under the broad deal reached this week to stem the euro-zone's financial crisis, holders of credit-default swaps on Greek government bonds aren't expected to receive any payout, even though a preliminary agreement between financial institutions and European policy makers would recognize just half the face value of some Greek debt.

The decision not to trigger the swaps raises questions about the value of the insurance-like contracts and exposes the limitations of the hedging strategies that banks and investors have come to rely on. The swaps are widely used by bondholders and major banks to defuse a wide range of risks, and by traders to bet on market trends. If the swaps don't pay out when bonds default, banks and funds that bought the insurance may face losses they thought they had hedged.

In the case of Greece, losses appear to be manageable because of the country's relatively small size. Up to $3.7 billion in credit-default swap, or CDS, payments would change hands in the event of a default, a far cry from Greece's €350 billion ($496 billion) government debt.

Global markets applauded the euro-zone deal, with stock and bond prices rallying. But some market observers warn that Thursday's decision could prompt investors to back away from trading swaps on other European countries, potentially reducing demand for government bonds and further constraining credit.

"You need the real money guys, the banks, to view [credit-default swaps] as a viable contract for CDS to be a real market," said Adam Fisher, chief investment officer at hedge fund Commonwealth Opportunity Master Fund Ltd., and a trader of sovereign credit-default swaps. The deal reached Thursday, he said, could "kill off the market."

Many U.S. and European banks purchase the default swaps on sovereign bonds to hedge their exposures to individual countries, or financial institutions and corporations they have lending or other relationships with. Buyers of the swaps make periodic payments to sellers in exchange for the protection, and if bonds default, the sellers make payouts to the buyers.

The deal European leaders reached with banks will see some private holders of Greek debt accepting what they call a "voluntary" 50% reduction in the principal amounts they are owed.

That is significant because the terms governing credit-default swaps on European sovereign bonds imply that a voluntary debt restructuring won't trigger payouts to buyers of protection.

European leaders have repeatedly signaled over the past year their desire to avoid debt defaults that would trigger credit-default swap payouts.

Politicians have been loath to devise solutions to the debt crisis that end up rewarding speculators and providing them with a windfall from swaps payouts.

"I don't think it's a surprise....People have been aware that European policy makers were trying to avoid" an outcome that would trigger credit-default swap payouts, said Otis Casey, director of credit research at data provider Markit.

Even so, the failure of the swaps to pay out could push some investors out of the market for European government debt, some investors said.

"If you owned a sovereign bond and you got scared because you bought CDS thinking it would pay out, you'll realize you would have been better off just selling your bond—and you'll just get rid of everything," said Ashish Shah, co-head of credit at AllianceBernstein.

The cost of default insurance on Greece tumbled Thursday but remains high, showing the country is still far from resolving its debt woes even with the latest deal. Analysts say Greece could still end up defaulting on its obligations or forcing all bondholders to take losses, an outcome that could trigger swap payouts. Default swap costs narrowed for other European countries, too.

Concerns about the possible ripple effects of a default swept financial markets this fall, prompting major banks to offer more information about their exposure to European economies.

The biggest U.S. lenders don't stand to lose much on the Greek "haircut." A bigger issue is exposure to economies such as Portugal and Ireland, and much bigger countries such as Spain, Italy and even triple-A-rated France.