Opinion: Hey protesters: Look at what Europe just did to banks!


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The European Union’s late-night deal to save Greece from defaulting on its bonds had two ugly elements for banks and other private investors in Greek debt. Those who resent the financial industry for recovering so much faster than anyone else from Wall Street’s epic collapse may find some satisfaction in this development. For everyone else, it’s a little troubling.

A centerpiece of Greece’s rescue is a deal that EU leaders negotiated with representatives of private investors, led by a banking trade group called the Institute of International Finance. The deal calls for investors to voluntarily agree to write off 50% of the Greek debt they hold in exchange for a guarantee that they’ll be repaid on the rest.


Although it’s better than a 100% loss, a 50% haircut is still pretty bad, at least for those who paid face value for Greek bonds. What makes it worse, though, is the characterizing that the loss is voluntary. That appears to prevent holders of the debt from cashing in the credit default swaps they bought as insurance on the bonds.

To the extent that the average person knows anything about credit default swaps, he or she probably thinks they’re exotic and risky financial instruments that amplified the impact of Lehman Bros.’ demise. In fact, they can be a useful tool for hedging risk. And if investors can’t hedge, they’ll be less willing to take chances with their money, restricting the flow of capital. That’s a bad thing for the economy.

Anyway, the EU’s move undermined swaps on sovereign debt, if not more broadly. That has some traders worried about even bigger problems to come as other European countries come under fiscal pressure. Here’s a telling, although unfortunately anonymous, quote from a Reuters piece:

‘People talk about Greek CDS triggering being destabilizing, when it’s really the opposite,’ said one global credit trading head at a major European bank. ‘If there is a 50% haircut and it’s voluntary, then my worry is all my sovereign CDS protection in Europe is useless, and my net exposure [to European sovereigns] is much higher. The next level will be calculating how much actual exposure people have, and how much is hedged out by CDS -- the exposures could be much bigger.’

That’s a worse-case scenario, but it’s a sentiment echoed here and here. You might argue that the hedging enabled by swaps is part of the problem because it increases the supply of money for countries like Greece -- in other words, it helps supply the rope they hang themselves with. Personally, I think it’s a good thing that the private investors holding Greek debt are taking it on the chin. There’s a moral hazard to forgiving bad debts. But I wonder why the public holders for Greek debt, such as the International Monetary Fund, weren’t included. If losses help enforce market discipline, shouldn’t the same lessons apply to all investors?

That’s a real question, not a rhetorical one. Finance wizards, weigh in with your comments below!


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