Will CDS Tackle the European Financial System?

The European sovereign debt crisis has been festering for nearly three years, and some observers wonder whether the credit default swaps (CDS) that have been written on the government of Greece, Ireland, Italy, Portugal and Spain represent another source of risk for the world's financial institutions.

A credit default swap is a financial instrument in which the buyer of the instrument makes a series of payments, called the spread, to the seller for a specified period of time, which is known as the maturity of the instrument. In return, the seller will make compensation to the buyer in specified amount, called the notional amount, if there is a credit event (i.e., a default).

Greece, Ireland, Italy, Portugal and Spain have been at the forefront of the European sovereign debt crisis that has been festering for nearly three years.

Wells Fargo economists say the notional value of the CDS contracts that have been written on government bonds of those five countries totals an eye-popping €500 billion though net CDS exposure is much more manageable at €40 billion.

However, CDS exposure, whether measured on a net or even on a gross basis, is small compared to the outstanding government debt of five countries that totals €3.3 trillion.

In our view, observers should not focus on CDS in isolation. Rather, their attention should be riveted to the solvency of those European governments. After all, a credit event, which would trigger the CDS contracts, would not occur unless a European government defaulted, economist Jay Bryson wrote in a note to clients.

Observers should be especially concerned about the potential risk to the European financial system posed by the €2 trillion worth of outstanding Italian government debt. A restructuring of Italian government debt, should it occur, would cause European banks to take capital charges that would total hundreds of billions of euros.

In September 2008, American International Group Inc (AIG) was brought down by the CDS it had written against collateralized debt obligations (CDOs) that were backed by sub-prime mortgages. However, ultimately it was the inability of subprime borrowers to service their mortgages, not the CDS contracts per se, that doomed AIG.

In that regard, there is some uncertainty regarding the applicability of the CDS contracts to a debt restructuring. In the case of Greek government debt, the International Swaps and Derivatives Association (ISDA) has announced that the restructuring proposed in October may not qualify as a credit event if it is voluntary. In the event of a voluntary restructuring, CDS contracts would not be triggered. However, negotiations about the restructuring of Greek government debt are ongoing, and no final determination has yet been made regarding a credit event.

The bottom line is that we do not lie awake at night worrying about the implications for the European financial system of CDS written on European sovereign debt. The nightmare of potential debt restructuring, especially for Italy, is bad enough to prevent a restful night's sleep, added Bryson.