The market seems to be pricing in an orderly Greek default or a successful "firewall" around the potential instability. Are the unknowns really all known?
Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know. (Donald Rumsfeld)
My contention regarding Greece has been that they cannot be allowed to default because of a tremendously leverage system. This contention remains unchanged.Below, the excerpt from KWN, indicates the problems confronting the system. Ten years ago Greece defaulting would not have been noticed but today, in a world where the CDS market has gone from $60 billion to over $600 trillion in a decade, and needs another $100 trillion in new debt over the next decade, Greece is a line drawn in the sand, apparently even if they burn it to the ground.
Note the discussion of hypothecation. He is saying that customer accounts have been used two to three times to serve as collateral. And should their money disappear as it will when things fly apart, it will have been perfectly legal because all of this paper was rated AAA when it was purchased. (This is why you will not see any widespread compliance audits even in the wake of MF Global). At leverage of 500 to 1 all equity is wiped out after a 0.2 percent decline or default.
One thing that isn’t talked about much, although I did receive a note today from UBS regarding it, is derivates related to bond insurance...There are basically three times the amount of bonds out there, existing in contracts, to insure those bonds. Now you have to remember that a lot of these contracts were signed when all of these bonds were considered AAA rated. People didn’t believe they would default.
So their is huge exposure in these dangerous contracts. There was one contract I saw that was going to pay 500 to 1 for the loss. These things are incredibly toxic contracts confronting the system right now. We don’t know who the counterparties are, and in many cases it’s hypothecated two or three times and it’s something that’s worldwide.
We are looking at financial Armageddon. This is just awful, Lehman times 1,000. This is why they are going to all of these crazy extremes and calisthenics to make it seem like Greece is not defaulting so the bond insurance doesn’t kick in.
As of now, most of the public discussion has centered on potential contagion among the banks as most of the Greek sovereign debit is held by the European banking community.
Traders, however, fear that the real risk is in the area of credit default swaps (CDS). They are insurance policies, individually written, that basically say - if Greece defaults, we’ll pay you what they should have.
Credit default swaps have grown exponentially over the last decade. Since they are individually written, there is no clear visible record of how many CDS contracts are outstanding. Also unknown is who is involved. The two parties obviously know who the counter-party is but there is no public record that would allow a regulator or a third party to find out who was involved.
No one knows how much CDS exposure there is on Greek debt but is assumed to be a lot. Banks and others looked at the very high and attractive yields on Greek bonds and began salivating. But, what about that risk - better buy some insurance.
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