The Unintended Consequences Machine Fires Up Again
You may not think this is very important or will not have any effect on you. Greece has had some real problems as of late. I hope you have noticed. Well, Wednesday night, the European Union reached a “voluntary”, as in gun to the head, deal regarding Greek Sovereign Debt.(Think US Treasury Bonds) The bondholders will get “new” issue bonds at 50% value of the old ones. OUCH!
OK, so why will this affect the US RE Investment Market? 2 Reasons:
Credit Default Swaps
Think of a Credit Default Swap (CDS) as a type of insurance policy. Let’s say Pension Plan A buys $1M of Italian 5yr Bonds. Pension Plan A has a risk of Italian Default over a 5yr period. The Pension manager can do 2 things to lessen the funds risk of default. (1. Nothing (2. Go into the CDS Market and purchase insurance from a counter party that guarantees payment of the full face amount of the Bonds, if Italy defaulted on payment during the 5yr period. That is as simply as I can put the CDS Concept.
Well there is a whole set of rules that govern CDS. Here’s where it get’s tricky, we have one set of rules for the US and one set of rules for Europe. Now, you see where this is headed. There are rules for when and how a Default is defined. Not to get way to technical but, the European Rule Keepers have decided this 50% hair cut IS NOT A CREDIT DEFAULT EVENT. Surprise, Surprise!!
No trigger, no CDS pay out. Now, kiss the CDS market good-bye. How is that bad????
CREDIT WILL TIGHTEN FURTHER. Hedge Funds, Pension Funds, Insurance Companies will now be more reluctant to invest in bonds, mortgage backed securities, ect. if there is no hedge to lessen risk of default. Europe just signaled Investors they are willing to gut them like a fish.
If you are confused it’s OK. Think of it this way; ½ of your house is on fire but your homeowners policy won’t pay the claim for damage. You want to live in the good half of the house but, the City condemned the whole house. You can’t get ½ of your premium payments back either. Would you continue to buy homeowners insurance? (See Diagram Below)
The Cost of Borrowing
I’m not defending lenders in any way here. We, as RE Investors, are very familiar with private lenders. Hedge Funds, Pension Funds and Insurance co.’s are some of the largest private lenders in the World. If they are unable to adequately hedge their risk when lending, I see only one alternative, A Larger Risk Premium charged to the borrower.
That can come in the form of higher fees associated with loans or higher interest rates on borrowed funds or both. The fed will not be able to control these higher rates. Traditional lenders will have no choice but to follow.
Another aside, I know an investor could never totally protect against default risk. So that leaves me wondering; why would I want to take a total risk of default by buying bonds that may pay me or default leaving me with squat? Especially if my job as a risk manager depends on a careful investment policy.
Are there any positives from this Bondholder scalping? Yes. I think from this point forward, closer due diligence will be the order of the day. Bond Issuers will be forced by the markets to provide more accurate information regarding their issues. Audit firms will have to get their S$$T together.
All I got to say is these European leaders are changing the rules at halftime expecting the same outcome in the second half of play. Europe and the US base all their FIXES on a Growth Model , which is dubious at best. Stay tuned, this will be very interesting to watch.
Edit Note: After I wrote this the WSJ came out with this article : This information is my opinion. It is meant to inform the reader. I do not own any CDS, MBS that I am aware of. This is not investment advice. I am not endorsing any derivative vehicle of investment. I’m not an attorney. This is not legal advice. Please consult your financial and legal advisor prior to investing. Don’t shoot me, I’m just the piano player…
Comments (2)
Dennis, I saw the Fitch article.Man, this is some serious stuff. I think that the powers that be must reverse their stance. In the big picture, the number of cds contracts is not that big. Risk/Reward, pay out 300million or crash the cds market. Thanks Dennis!
Mike Morrison, over 14 years ago
Fitch said today that the 50% haircut is a default. So the plot is thickening! Great post. This WILL impact real estate investing as the global credit market crashes and burns.
Dennis F., over 14 years ago