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Euro-zone Credit Crunch & Shanghai ShakeoutGary Dorsch Until mid-April, few traders knew much about the credit default swap (CDS) markets. They’re traded on an unregulated, over-the-counter market, and far from the public’s view. Yet nowadays, the CDS market has become a major battleground between high-stakes speculators and Euro-zone politicians, with the fate of the Euro currency hanging in the balance. In turn, the violent swings in the CDS markets are having a profound impact on the global bond, commodity, currency, and stock markets. Credit default swaps have existed since the early 1990’s, but the volume of trading began to increase dramatically in 2003. By December 2007, the CDS markets had grown in size to $62-trillion of contracts outstanding, before shrinking to $38-trillion by the end of 2008. Huge throngs of “naked” short sellers were wiped-out in the CDS market following after Lehman Brothers defaulted on $365-billion of liabilities, which were settled at just 8-cents on the dollar. Fourteen months later, the obscure CDS markets were again at the center of another major financial crisis, this time, raising the specter of a sovereign debt default. CDS traders were among the first to recognize that the government of Greece was technically insolvent, and unable to repay its €300-billion of outstanding debt. The size of Greece’s debt rivals the size of Lehman’s, when it defaulted, and is almost four times of the size of Argentina’s debt, when it defaulted in 2001. Typically, a bond-holder can hedge against the risk of default by purchasing a CDS contract, and making quarterly insurance payments to the CDS seller. If a company or a national government defaults on its debt obligations, seeks a restructuring, or declares bankruptcy, the CDS seller is obligated to pay the CDS buyer the par value of the bond, in exchange for physical delivery of the bond. Most CDS contracts are in the $10-to-$20-million range with maturities of 1-to-10-years. However, speculators can buy “naked” CDS contracts without actually owning the underlying bond. Likewise, sellers of CDS contracts might not have sufficient funds to cover their obligations, in the event of a default. These “naked” credit default swaps constitute the majority of trading volume, and permit banks and hedge funds to place bets on whether or not a company, or even a country, will default on it debts. The nature of CDS trading, - which doesn’t require reporting of transactions to a government agency, - is such, that CDS speculators have an incentive to push companies or countries toward bankruptcy. CDS traders nearly toppled the Greek finance ministry, and are now betting on defaults in Euro-zone junk bonds. Attracted to the highly indebted Greek bond market like vultures to a decaying corpse, the CDS traders at major banks and hedge funds moved in for the kill in April.
Trading in credit default swaps linked to Greek debt surged over the past year, prior to the upward explosion in CDS rates in late April and early May. The overall amount of insurance on Greek debt hit $85-billion in February, compared with $38-billion a year earlier. CDS speculators nearly hit the jackpot on May 7th, when the cost of insuring $10-million of Greek bonds soared to $1.2-million, worsening the budgetary plight of Greece and bringing it closer the specter of default. Prior to the climactic surge in late April and early May, each time CDS traders bid-up the cost of insuring Greek bonds against default, Euro-zone politicians and the IMF were quickly forced to ante-up more bailout money. Initially, Euro-zone politicians pledged a paltry €22-Euros to prevent Athens from defaulting on its debts. When that gambit failed, the ante was raised to €45-billion. However, on April 26th, the S&P credit rating agency, - which usually lingers far behind the credit default curve, lit a fire in the CDS tinderbox, roiled Euro-zone politicians and shocked the global markets, by downgrading Greece’s €300-billion of debt three notches to junk status, at BB+. Greek CDS rates soared to 1,200-bps, and yields on Greece’s two-year notes jumped to 25.8-percent. Euro-zone politicians and the IMF quickly raised the ante for the Greek bailout to €110-billion. German finance minister Wolfgang Schauble had warned on April 20th, of another global financial meltdown. “We cannot allow the bankruptcy of a Euro member state like Greece to turn into a second Lehman Brothers,” he told Der Spiegel. “Greece’s debts are all in Euros, and it isn’t clear who holds how much of those debts. The consequences of a national bankruptcy would be incalculable. Greece is just as systemically important as a major bank,” Schauble warned.
On May 6th, Greece’s 2-year CDS rate surged to a record 1,195-basis points, and triggered the historic “flash crash” on Wall Street, - an intra-day, 1,000-point meltdown in the Dow Jones Industrials, climaxed by a shocking 700-point drop, in less than 20-minutes, to below the psychological 10,000-level. Since the mainstream media was unfamiliar with the movements of the Greek CDS market, it peddled a story, that a computer glitch caused the “flash crash.” The rebellious CDS speculators in Greek bonds, refused to fold their cards, knowing that Athens would need to raise €50-billion for each of the next five years, in order to roll-over debts and pay interest. That adds up to €250-billion, easily topping the EU’s €110-billion bailout offer. On May 8-9th, European politicians, finance chiefs, central bankers, and officials from the IMF were taken aback, by the brazen CDS traders, and huddled behind closed doors for an emergency summit, trying to devise a decisive plan of action, that could stamp out the speculative attack against the Euro and to bring some calm into the Greek bond market. “We now see wolf-pack behavior, and if we will not stop these packs, they will tear the weaker countries apart,” Swedish Finance chief Anders Borg told reporters before the meeting. “We need resources to stop the market turmoil. If this goes on for more than a couple of days it will be very, very problematic for the recovery,” Borg warned on May 8th. French Prime Minister Francois Fillon added, “The joint action taken to save Greece will defeat and put an end to speculation which has been unleashed against this country and which represents an attack on the entire Euro zone.” On May 10th, after two-days of deliberations, the EU-leaders unveiled the financial equivalent of “shock-and-awe,” – a €750-billionpackage of standby funds and loan guarantees that could be tapped by Euro-zone governments shut-out of credit markets, plus central bank purchases of bonds, to steady markets, - all designed to crush CDS speculators by its sheer scale. The European Central Bank (ECB) immediately began implementing its part of a deal, - unleashing the “nuclear option,” - buying Greek and Portuguese government bonds in the open market.
With the ECB pledging to buy Greek bonds, yields on its two-year note plunged in the blink of an eye, from an intra-day high of 24%, to 7.5-percent. Since May 10th, the ECB has effectively locked Greece’s two-year yield between 7% and 9.5-percent. However, the cost of insuring Greek debt is still hovering around 850-bps today, very high by historical standards. CDS traders reckon that at some point, Athens might grow tired of trying to pay-off an insurmountable mountain of debt, and will demand a restructuring, - a haircut of 50% or more for its creditors. Since May 10th, the EU’s “shock and awe” effect has worn-off. The EuroStoxx-600 Index briefly fell to new lows on May 25th, and the Athens stock index fell to within 5% of its March 2009 lows. The Euro failed to gain any traction, and is still sliding lower along a slippery slope towards $1.20 versus US-dollar. While the “Big-Bang” bailout has subdued the threat of a Greek debt default, the next lethal phase of the European debt crisis is starting to materialize, - a frightful situation where European banks become unwilling to lend money to the private sector. To read the rest of this article, please click on the hyper-link below: http://sirchartsalot.com/article.php?id=134 ### Gary Dorsch 321gold Ltd |
