This writing "Calling for Revolution in America, It's Not Just Me" is my fundamental manifesto.

Society is like a stew. If not stirred frequently, the scum rises to the top.” – Edward Abbey

Saturday, June 18, 2011

EuroZone's Sudden Re-Definition of Default Will Roil the Markets

The initial reaction to the latest scheme out of Europe on Friday was knee jerk, another rally, which largely fizzled. When the dust settled, some commentary materialized ["The Euro Zone's Wacky Plan" by Mercenary Trader] critiquing what seems to be a hair-brain approach of "voluntary extensions" of maturing debt and hopefully a "voluntary restructuring" that avoids the "technical definition of default."

When I see plans like this, I automatically apply my "smoke and fire" theorem. Here, I suspect a financial player (or several) among the Too Big To Fail racket probably has significant exposure to pay claims on the defaults. That's because, true to their nature, they end up over-trading this insurance. The over-trading is based on pure, unadulterated  moral hazard. Why not "extra insure" against sovereign default risk?It's going to end up socialized anyway.

Since the rackets that do this are dynamite-strapped, Too Big To Fails (TBTFs), they can always threaten to blow themselves up, if push comes to shove. Heck, at this stage it may even be the Fed or ECB involved in selling CDS (credit default) insurance to keep the game going through "back channels." Who would know when so little is subject to scrutiny. Accordingly, and perhaps fearing another AIG-style rescue saddling governments with even more socialized losses, they have sent instructions to their lackies to "prevent a technical default" whereby the Ponzi scheme collapses.

As Mercenary Trader asks, what happens to the buyers of the CDS paper? Clearly this is a zero-sum game, with the winners being the TBTF racket and the losers being those who bought the insurance. Once the players figure out how truly rigged and manipulated this default insurance market truly is, then the idea of hedging positions is thrown out the window. If you can't effectively hedge, then you need to get the true return on the underlying securities you hold. To even call this "unintended consequences" would be a real stretch. The result could be akin to the 1987 crash when players suddenly realized portfolio insurance wouldn't effectively hedge much of anything.

Mercenary Trader comment:

Some research suggests American banks have been aggressively selling CDS to European banks, which is pretty amazing if true -- considering Europe is where the fire is, and European banks are the ones holding the debt, this would be AIG redux (dumb premium collectors writing timebomb insurance, for pennies on the dollar, with no sense as to what the buyers know).

Unless maybe the American banks were smart enough to figure out the CDS sales are actually low risk because Europe couldn't afford to trigger a true "credit event," in which case team USA is betting the European buyers would be screwed by an insurance clause override enacted on their own side???  It's like the world's biggest high stakes poker game -- with taxpayers and citizens the clueless backers, taking none of the winnings and all of the pain.

My comment:

MT, If your suggestion that a "scam" around the definition of "default event" holds water, that means sovereign default insurance is largely worthless. If so there goes effective hedging. And if effective hedging is gone, then you get a redux of the 1987 portfolio insurance crash. An idiot would then say unintended consequence/whodathunk?

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