As we wait for Europe’s big weekend to unfold, here is an interesting thought, as generated by back and forth comments on recent pieces.
In The Eurozone’s Wacky Plan, we noted the latest hail Mary hope of a “non-default default” — a way to roll over Greece without triggering a credit event, with attending invalidation (or temporary bypass) of CDS insurance payouts.
We also noted how this could be very bad news for European holders of CDS insurance (the guys who bought as a legit exposure hedge), as their PIIG debt would be de facto compromised by a non-default default, but their hedges left worthless.
So here’s where it gets interesting….
In O Risk Manager Where Art Thou, we noted the below via Kash Mansori / John Mauldin:
?Why have European and American financial institutions behaved so differently when it comes to the PIGs? Specifically, why have American firms been so willing to sell default insurance to the Europeans, though they have not bought much PIG debt? And conversely, why have the Europeans systematically been so eager to buy insurance for their PIG debt, even at the very high price such insurance now commands? In essence, European firms have been betting that a PIG default will happen sooner rather than later, while US firms have been betting that default would happen later or not at all.?
So the original, logical question would be:
If the above is true, why in the world are American banks selling credit default swaps (CDS) to their old continent counterparts?
Considering Europe is where the fire is — and European banks are the leveraged kindling — you would think hawking tons of fire insurance to the guys in the hot zone is not such a wise idea!
If accurate, what we have here is a sort of “AIG redux:” A dumb premium collector (in this case American banks), collecting pennies on the dollar, for timebomb insurance sold to insiders (European banks) who presumably know their own risks (and thus have good reason for buying).
This makes American banks the willful suckers. Unless…
Unless maybe the American banks were smart enough to figure out the CDS sales are actually low risk because Europe couldn’t afford to let a true “credit event” be triggered, in which case team USA is betting team Europe buyers would be screwed by an insurance clause override enacted on their own side???
How beautiful would that be: I sell you cheap disaster insurance, making me look like the rube, because you know that the bomb you are sitting on is probably going to off.
But in a Hitchcockian twist, you don’t know that I know that the guys on YOUR SIDE are going to try their damnedest to invalidate the contract.
It’s like the famous scene from The Princess Bride:
“Clearly I cannot choose the wine in front of you…”
Or maybe it’s the world’s highest stakes poker game, with taxpayers and citizens the clueless backers, once again, sharing in none of the spoils and all of the pain.
I don’t know what the American banks were thinking selling all that CDS insurance to Europe (if Mansori’s analysis is correct). But I can imagine some form of revamped AIG-style logic ran through their heads:
“This stuff can’t actually trigger. They can’t afford to let it. It’s a building that will never burn down, so we can go whole hog selling fire insurance on it.”
And they could be wrong, of course. If we get a “Lehman 2.0 event,” or if negotiations get hung up on some final third party snag, or if the ISDA rules that a “credit event” has occurred regardless of French and German protest, the AIG bet goes kablooey.
But in that case, the imperative of further U.S. bank bailout — systemic risk, remember! — still puts the reward to risk proposition in favor of a profitable gamble. Heads they win, tails taxpayers lose. Thanks Timmy! Thanks Ben!
Regardless of how things turn out, this whole song and dance is further evidence of how deeply Darwinian and moral-hazard prone the entire financial system is.
Give a mouse a cookie and he’ll want a glass of milk. Give a connected player an asymmetrical edge and he’ll figure out a way to exploit it to the max, even if that means putting the whole system at risk — or rather, ESPECIALLY if it means putting the whole system at risk, because such increases the prospect of bailout.
As Canada Bill Jones opined, “It’s immoral to let a sucker keep his money.” The banks appear to believe that axiom wholeheartedly, and the fish (taxpayers) don’t even know they are sitting at the table.
JS
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