It has now been agreed that private holders of Greek government bonds will take a loss of 50% on their investments.

This ‘haircut’ will mean that private investors, by which I mean banks, will only get back half of what they lent Greece. Bad news for the banks, as well as bad news for anyone whose money was invested in those bonds by the banks. Those for example with investments or pensions with those banks that invested in Greek debt.

So, as with anything else of value you might expect the banks to insure themselves against such a loss, if that type of insurance was available.

Well it is, in the form of Credit Default Swaps (CDS). A CDS is similar to an ordinary insurance policy. If the borrower defaults on payments (a credit event) the CDS holder gets money and the CDS issuer gets the defaulted loan.

So, if the banks used a CDS to protect themselves against a Greek default then they get the money from the ‘insurer’ and the insurer gets the defaulted loan. The banks are therefore not affected by the 50% haircut. Bank happy, investors happy.

But it’s not that simple. The CDS insurance web is so entangled with all the other banking that triggering a large CDS payment would be disastrous for us all.

But worse, when you insure your car, house or life you have to have an ‘insurable interest’ in the item you are insuring. But with a CDS you don’t. So a CDS can be used as a vehicle for investors to gamble. Anyone can take a out a ‘bet’ that Greece for example will default on its loans. In this way vastly more would be paid out for a default than was actually lost. So much so that a large CDS credit event could be catastrophic.

So why isn’t this happening now that Greece has effectively defaulted by only having to pay back half the loans? Because the agreement that was reached ensured that the losses by the bank were ‘voluntary’. The banks are only going to enforce half the debt.

Therefore no credit event so no triggering of the CDS.

What a waste of money they were then for both investors and speculators then.

There is a whole mountain of CDSs. About $26 trillion worth or so of index CDSs, LCDSs, BDSs ….. I wonder how much these cost people to set up and what now is the reality of many of these actually paying out? And if they do there is always the danger that it would bring the system down anyway.

Or else why did the recent agreement with the banks over Greek debt make sure that a credit event was not triggered?

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