It is becoming less clear whether those sovereign CDS contracts really offer effective “insurance” against default. And that in turn raises a more unnerving question: if the exposures of the large European banks were measured in gross, not net, terms, just how much more vulnerable might they be to sovereign shocks? Or, to put it another way, could the problems now hanging over eurozone banks and bond markets be about to get worse, due to the state of the sovereign CDS sector?
The issue that has sparked this debate is, of course, Greece. When the eurozone leaders announced their plans to restructure Greek bonds they failed to meet – or, more accurately, deliberately missed – the fine print of “default” under ISDA rules. Most notably, the standard ISDA sovereign CDS contract says that pay-outs can only be made when a restructuring is mandatory, or a collective action clause invoked. However, it seems that 90 per cent of Greek government bonds do not have collective action clauses; and the October 26 announcement presented the haircut as “voluntary”. Thus ISDA has concluded that “the exchange is not binding on all debt holders”, so the CDS cannot be activated – even though losses on Greek bonds may well be bigger than at Dynegy.
ISDA may well be right; given the magnitude of the turmoil now shaping the eurozone financial system, $3.7 billion is barely a rounding error. But the crucial question now is what happens to the wider sovereign CDS market – and banks. It is unclear how far eurozone banks have used CDS to hedge their exposures to eurozone debt. However, the published level of outstanding sovereign CDS for Italy and France is more than $40 billion, and the Bank for International Settlements recently suggested that US banks have now extended over $500 billion worth of protection to eurozone counterparties on Italian, French, Irish, Greek and Portuguese sovereign and corporate debt.
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