When Greece Defaults, the Credit Default Swap Dominoes Fall

A default by any other name is still a default. When Greece defaults, the inter-connected chains of credit default swaps will fall like dominoes.

For your Superbowl half-time reading, here is a brief summary of the situation in Europe:

1. Greece is poised to default, the end-game everyone anticipated in 2011. It is not a matter of if but when.

2. That default will trigger credit-default swap contracts, derivatives known as CDS that protect the owner from events such as default.

3. This will implode the shadow-banking system and the visible banking system, as those who sold the CDS (financial institutions) do not have enough cash or assets to pay the owners of the CDS.

4. The general idea is that sovereign default is very unlikely, so you can sell protection (CDS) against that possibility for a low premium, and cover that bet by buying your own protection from another player.

5. If that player (counterparty) can’t pay you off, then you can’t meet your obligations on the CDS you originated and sold.

6. So the failure of one counterparty can trigger a systemic failure akin to a row of dominoes being toppled by the fall of one domino.

7. To avoid such a CDS-triggered collapse, the European Union and its proxy agencies (European Central Bank, etc.) are attempting to call a default by Greece something other than “default.”

8. This will theoretically keep the first domino–a credit-default swap–from falling. In other words, if we call a default by some other name, then it isn’t a default.

9. Those absorbing the losses caused by a Greek default (and let’s stipulate that this references owners of Greek debt who bought CDS as insurance, not speculators who leveraged CDS at 30X the actual bond value) will want to cash in their insurance, i.e. the CDS they own against a Greek default. They have every incentive to demand a default be recognized as a default. If they accept the official plan to avoid calling a default a default, then all the losses will be theirs and none will fall to the counterparties who sold them the CDS.

10. How is this fair?

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