Bond holders of Greek debt, who have protected their investment by CDS insurance, might not get paid the money they lost, although ISDA set the CDS auction for March 19 after deciding on a credit event and therefore a trigger for the swaps. So, a $100,000 bond has now incurred a loss of $54K to its holder, replacing the rest with new bonds issued today. If that bond was insured by holding CDS though, the CDS payout that has now been triggered will be substantially lower than the incurred losses. Therefore hedging the bond’s risk will turn out to be an even worse investment and may lead to actually kill the sovereign CDS market according to Reuters!
Let’s say you place a bet on a coin flip. You risk $10 on heads, the coin is midair and you suddenly have a hunch that you are going to lose. You quickly bet another $10 on tails as an insurance of your first bet; in other words hedging your risk under excellent terms. The coin drops to ground showing tails and you expect to break even. However the insurance you paid $10 for, returns $5 instead of $10. You end up losing 5$ although you were insured. To make the example even more comparable with CDS terminology, you invest $10,000 betting that the outcome of a thousand coin flips will be heads. 200 coin flips take place each year and 110 out of those 200 flips end up heads. Your investment wins 5% each year. After 2 years of coin flipping (or holding the bond), it’s publicly known that the coin has been replaced by a rigged one, which is enormously biased towards tails (default is imminent). Your investment suddenly is at risk and you want to hedge the risk. You bet $10,000 more on tails (buying Credit Default Swaps) wanting to make back what you are going to lose from your initial investment, although now you don’t get paid 1-1 on your money, since we all know that the coin is rigged. Thus, you end up minimizing the loss (bond haircut minus CDS payout) but not entirely.
Betting on heads, which stands for investing in government bonds, yielded 5% per year. Owning Greek debt may have seemed a nice idea for some investors earning 5% annually. When the bonds would expire, bond holders would sell the debt back to Greece, having made money in the process. Obviously the debt would still be there for the country, but who actually paid that annual 5% yield? There are hedge funds and investors who risked their money betting on Greek default (tails in our example) right from the start. They even invested in naked CDS, meaning they didn’t hold any bonds, much like the bond holders who didn’t insure their bonds. Insuring those bonds cost $22,000 annually per $10 million debt in 2008 but nowadays the protection would cost about $7.6 million as NY Times state! Think about it, Greece was likely to default like the coin flips ending tails. Investors who bet on heads and hold bonds are going to lose, while those who risked on tails and CDS are going to win, as the 5-Year Greek CDS graph implies.
It’s like a huge coin flip on Greek default with bond holders losing their bet, although the payouts are yet to be determined.
