When is a Debt Default not a “Credit Event?”

In this week’s Barron’s, Alan Abelson looks askance at the non-default default in Greece.

All bombast aside, what makes this issue so fascinating to me is not whether or not Greece has or has not technically defaulted. Rather, it is that there is a committee of conflicted interested parties rendering a verdict on that issue.

Funny, that sort of group declaration is not required when a payout determination occurs when a futures contract or an option must settle.

No committee decision is required. Which (again) is why Credit Default Swaps sound a lot more like Insurance than they do other tradeable assets.

Regardless, here is Barron’s:

“Rogues lying wasn’t the problem with another recent instance of March Madness on foreign shores. A panel of five investment firms and 10 banks chosen by the International Swaps and Derivatives Association has told the world it need not fear that Greece’s failure to pay its humongous debts would trigger payments mounting into the billions of dollars on those instruments of mass destruction, credit-default swaps, thanks to those 15 worthies unanimously declaring such losses are not “a credit event.”

Keep in mind, please, that credit-default swaps presumably serve as insurance against loss for holders of bonds and sovereign debt. But the panels saw fit out of the goodness of their hearts to make an exception for Greek debt. If something that would touch off payments of over $3 billion doesn’t qualify as “a credit event,” what is it then—a walk in the park with Angela?

Barry Ritholtz of Fusion IQ reminds us in his latest dispatch of the epic credit-default-swaps folly indulged in by AIG not all that long ago when the firm wrote upwards of $3 trillion worth of them, while “reserving zero dollars against potential claims.” It provided a bonanza for the insurer until the whole house of cards collapsed. At that point, AIG went belly-up and good old Uncle Sam found himself on the hook for a bundle. As to the definitional high-jinks engaged in by the panel on Greece to avoid touching off an avalanche of credit-default payments, Barry fumes: “Damned if I can figure it out.”

Why does it matter if Credit Default Swaps are not Insurance?

The key to that question is what the state insurance regulators actually from insurers — reserves (a lot of them) to make payments in the event of any such credit event occurs. Industry groups (ISDA included) do not require reserves. Not one penny.

Why does that matter? Swaps are ALOT less profitable as an insurance product than they are as a trading vehicle. THAT is the primary issue which we all should be concerned about. Its how AIG got itself into so much trouble, and we could very well see a repeat unless this gets resolved sooner than later.

>

Source:
March Madness
ALAN ABELSON
Barron’s MARCH 3, 2012
http://online.barrons.com/article/SB50001424052748704097904577249353146681684.html