Gustavo Ballvé on October 31st, 2011
Banks, Diversified financials, Food for thought, Industries, Portfolio Management, Risk management, Signal or Noise

Two very recent stories on CDSs (credit default swaps) highlight the issue of Risk. Risk has a lot of aspects to it and some get overlooked, such as counterpart risk, process risk, instrument risk (liquidity, clarity of regulations, how tested it was in real-life distressed situation etc.)… Not reading the fine print, for instance, has led more investors astray than they would like to confess. Much has been said about CDO-Squared and complex instruments in general, but the CDS was actually not supposed to be complex. Even so, investors in Greek debt CDSs are finding that “default” may not be what they thought it was… And another side of the debate is counterpart risk: what if the instrument is good, the writing is clear and so on – but the counterparts (whoever they are in this immensely interconnected financial world) just can’t honor their side of the deal? Who do you turn to then?

This NYT story highlights that some financial instruments are too untested to trust completely. Apparently there’s enough leeway built into the CDS contract for this “voluntary” deal (to take a 50% haircut on Greek debt) NOT to be considered a default on the terms of the CDS, meaning people who bought “insurance” get nothing. Another thing that captures our attention is that there’s a committee that decides whether or not this is an event of default – and it would seem like a one-sided committee in favor of CDS investors. However, the big banks’ incentives are more aligned towards making the agreed debt deal come through – to save 50% and perhaps avoid a larger meltdown. Not surprisingly, this committee has already indicated that this “voluntary” swap does not constitute default…

And this Bloomberg story addresses the counterpart risk issue: in this immensely interconnected financial system, it just may be that too much risk-spreading actually increases the chances of “contagion” or “viral spread” of troubles. If that happens with a over-the-counter, not-centrally-cleared instrument such as the CDS, there could be big consequences.

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