Part 5: Insuring Against Default and Higher Rollover Risk

May 8, 2012

Presentation (.pdf)

As the interest rates rose, holders of sovereign debt purchased credit default swaps (CDS)-essentially insurance against default. However, by late 2011 Greek CDS stopped trading when markets gave Greece a 50 percent chance of default. Meanwhile the European Central Bank had become the only entity keeping Greece's banks afloat. Default would weaken Greek banks because they held about 20 percent of the government's debt, and therefore markets stopped rolling over Greek bank debt due to fears that they would no longer honor obligations-which in turn meant that Greek banks could not roll over funding of Greek government debt.


Christopher Waller: Now, another thing that we can look at besides interest rates on the debt are what we call credit default swaps. These things got a very bad name in the first financial crisis. But they're just simple—no, I don't want to say they're simple. They're simple—yes, they are—they're simple insurance contracts, that's all they are. So if you're holding a debt of somebody and you're worried that they're not going to pay you off, you can go buy insurance against that. Just like if you're worried your car is going to crash, you can go buy insurance against that. So we call these things credit default swaps. So what I'm doing is I'm swapping the default risk from me to somebody else. Just like if I buy auto insurance, I'm swapping the risk on my financial loss on the car to the insurance company.

Now, how does it work? Somebody who sells a CDS will pay you the value of the defaulted debt in the event of a default. So if I'm a buyer and I buy this insurance, on net between what my partial payout is on the defaulted debt and the insurance, I get made whole. So a very simple example. If Greece or somebody were to default 100 percent on the debt, the insurance company gives me the full face value of the debt. So I'm made whole—the seller, the CDS bears all the risk.

Now, of course, just like insurance, if you're selling this insurance, you're going to raise the price of that insurance as the probability of default goes up. I mean, it's just very simple. So the higher the probability of default, the higher the price charged to acquire this insurance. So again, we often look at the price of CDS to tell us as policymakers, what does the market think is going to happen and what are the probabilities of default? You can kind of translate these prices into probabilities. So these are the CDS prices. Okay, here's Germany. Well, nothing's happened. Nobody is worried about Germany really defaulting. Here's a little blip, and a little bit over here. There's Ireland, nothing. And then up and then down and then up again and then back down. Here's Italy, basically the same as Germany, a little higher, a little higher and then this last summer and fall, big jump in CDS prices. Here's Portugal. Spain, again trending up. And again, I have to put the Greeks off on a separate slide. Notice that it just stops. Because at some point, everybody knew what? They're going to default. Who's going to sell insurance if you know it's going to hail your car out. It just stops. The market stops trading. It's just done, it's finished, so that's why it just ends.

Now, this basically—let's see if I can do this in my head real quick—this basically, it's almost 5,000 basis points which is 50 percentage points. It basically said, I believe there's a 50 percent chance of default. You're going to pay me 50 percentage points to get 100 back, if it doesn't default or if a default occurs. So they were placing a default at about 50/50 chance of occurring. Now, this rollover problem hits the governments. That's going to have repercussions on the financial system. Greek banks hold about 20 percent of Greek sovereign debt, about 60 billion euros. And so any default by the Greek government is going to mean a default on the Greek banks, their assets are going to be weakened, their capital are going to take hits, and the banks may go under.

So then the markets do this kind of backward induction. Well, if the Greek government defaults, they can't pay the banks, the banks are not going to be able to pay back any debt they've issued. So we're not going to rollover the debt to the banks either. So this meant that the Greek banks because they couldn't get funding couldn't rollover the debt for the Greek government. Starting around spring of 2009, the only institution keeping Greek banks alive was the European Central Bank. They couldn't get money from anybody. If it wasn't for the ECB, the Greek banking system would have completely collapsed in 2009.