Estimates are beginning to emerge on the total size of the Credit Default Swaps (CDS) for Greece. For a primer on this topic please see:
Part One: The Greece Bailout: Do Not Trigger The Bomb
Part Two: Bomb Triggered: ISDA Determines Greek Default A Credit Event
The media reported on Friday that the total size of the CDS after all "netting" took place was less than $3 billion. This number is probably accurate.
But what does "netting" mean?
The total size of the Greek Credit Default Swaps market (that we know about) is somewhere in the range of $70 billion. What the $3 billion netting number means (using a simplified example to help explain) is that $70 billion will have to be paid out on the Greek default from the entities that sold the insurance. $67 billion will be collected from the entities that bought the insurance, leaving only $3 billion after netting.
Sounds safe, right?
This would not be a problem if there were only 2 or 3 entities involved in the process, but there are thousands. Let's say that Tim, who runs a hedge fund, will owe $2 billion in insurance pay outs and he did not have any "hedges" or protections on his books. Mike, who also runs a hedge fund, purchased the insurance contracts from Tim.
This is great news for Mike who will collect $2 billion and not great news for Tim who must pay it out. In this simple example, which is currently taking place right now in the real world, the wonderful "netting" number does not help Tim at all.
What if Tim does not have $2 billion to make the payments? This is where things get interesting. Tim becomes a break in the chain the way that Lehman broke the chain back in 2008.
The derivatives market, based on the most recent data released, is now $708 trillion in size. Yes, that is a trillion. It is the size of the entire global stock market, times 10.
We have been told by Bank of America, Citigroup, and the European banks that there is nothing to worry about because after all these contracts are "netted" out the actual number is much smaller.
The European Central bank just pumped $1.4 trillion into the financial system in freshly printed cash. Is this enough to protect against all Greek Credit Default Swaps? We have no idea because we cannot see which banks or hedge funds have exposure.
Tim may have taken on $20 billion in Credit Default Swaps. Or he may have none.
What about Portugal? Is there an entity out there, similar to AIG, that is holding a massive amount of insurance on Portuguese debts? How about Spain or Italy?
Continuing down this path we are going to find out that all these banks "hedges" and "netting" are only as good as the entity that they purchased the insurance from.
Can a hedge fund who has been collecting massive insurance premiums over the past 5 years, millions in bonuses every quarter, just simply close their doors and walk away if a trade goes bad?
Of course they can. The market is not regulated. Heads they win, tails the tax payer or central bank will make the payments on the insurance. They can take two years off to travel, and then open up a new hedge fund.
The financial system is about to be walked through a very large test. This is all forward thinking, and it may take a long time to work through this process. Do not get frustrated if you turn on the news on Monday and they are talking about the color of tie that Mitt Romney likes to wear. The world was oblivious to what was taking place back in early 2008. It does not mean that you should be oblivious as well.
