The folks at Pragmatic Capitalism (PragCap) posted a blog today by Walter Kurtz titled “Time to Stop Fearing the Greek CDS Bogeyman.”  The article essentially presents an argument that the market shouldn’t be overly concerned about a potential significant payout by writers – banks, insurance companies – of credit default swaps (CDS) on Greek sovereign debt.

Part of this topic relates to Greek lawmakers wanting to retroactively change the existing Greek-law bond agreements by including a collective action clause (CAC) that would enable a supermajority of bondholders to force a debt restructuring on all holders.  S&P wrote that it would consider this amendment an action of default, hence triggering a default and a CDS payout.

PragCap includes some useful charts from SoberLook.com and outlines four points regarding why a CDS trigger would not be a concern.  The first and last points relate to CDS being marked to market.

This argument may be valid if most or all of the CDS written were done so prior to mid-2010 when laws were imposed for writers of derivatives contracts to post collateral.  However, these laws were not imposed retroactively.  We can thank Warren Buffett, as he lobbied Congress in 2009 and 2010 against making this law retroactive, which is fair (unlike the CAC insertion mentioned above).  Note, however, at the time Berkshire Hathaway had $63B+ of derivatives contracts of which it was at risk of being asked to provide collateral of between 10% and 20% of the total amount, or roughly $7B to $14B of collateral.  Nevertheless, since the law is not retroactive, Berkshire doesn’t have to post collateral for these contracts, which are mostly index derivatives, incidentally.

Our sense is that a lot of the outstanding Greek sovereign debt CDS were written prior to the collateral posting requirements.  Ergo, the writers of said CDS – banks, insurance companies – have not posted collateral, just like Berkshire Hathaway has not posted collateral for its derivatives written prior to the change in rules. 

We shall see…

According to Coller Capital, and highlighted by Jason Kelly at Bloomberg, investors’ newfound selectivity will help eliminate 20% of private equity firms. Just one of many reasons is alluded to by the June 13, 2011 bankruptcy filing by Perkins and Marie Callender's restaurant, a portfolio company of Castle Harlan, which will lose all of its $245 million investment.

This isn't new information or surprising to many deal-by-deal practitioners such as Coventry League, as we witness the level of talent (or lack thereof) on a continual basis (in public and private equity investing) and wrote about the upcoming debt overhang at over-levered portfolio companies (De-leveraged Buyouts; Nov. 2009).  Nevertheless, more transparency about these zombie-like private equity firms is positive for the industry since many of these below average firms and professionals tend to overbid and under-perform from a post-acquisition operating perspective. 

  Unfortunately, the investment and M&A industry is not like, say, professional sports.  In sports, athletes are continually evaluated mostly on an objective basis and are displaced by those who demonstrate better prospects and abilities.  Exceptions, to an extent, are made for legacy athletes (e.g., Brett Favre) – sometimes. In investing, especially at firms that don’t charge fees based on performance (think wealth management-type firms and mutual funds), many professionals exist not necessarily by their objective abilities and performance but rather mostly by subjective reasons that often include cosmetic aspects of one’s background, personal connections and whatnot. 

Additionally, the industry perpetuates a myth that it is practically impossible to consistently outperform market indices (read: collection of companies selected by preset screens) using similar risk (typically defined using price fluctuations with time horizons less than a year). 

Why apparently sophisticated investors, including high net-worth individuals and institutional investors continue to deploy capital irresponsibly is puzzling.  This is best addressed in a separate blog; however, we'll leave you with this: InkStop.  It was a retail chain outlet focused on selling ink cartridges for printers.  The business model was terrible (high fixed costs; low-priced products; market trend of low-cost, quick-delivery Internet options; etc.).   Yet, several "sophisticated" investors found this business model attractive enough to actually request an investment memorandum and subsequently invest in the company.  After the company's prompt fall to bankruptcy, some of these same investors amazingly cried foul.  Moral of the story: Stupid is as stupid does.  

Against the wishes of global banks and investors, but with the wishes of its citizens, Iceland allowed its too-big-to-fail institutions to default (i.e., no taxpayer-funded bailouts).  Guess what?  A Great Depression in Iceland didn’t occur.  Rather, its economy has stabilized  and is performing well, relatively speaking. 

Elsewhere, in contrast, leaders have been using fear-mongering and outright threats (if citizens don’t enable massive bailouts, then the equivalent of financial Armageddon will happen).  The latter is disturbing because leaders are essentially saying if citizens don’t permit bailouts, then civil-servant leaders will make things worse than otherwise (drastically reduce public pensions, services, etc.).  If these were company managers, their actions would be considered fraud by a rational Board of Directors and promptly removed from service. 

A good example of the aforementioned fraud and potential fraud on citizens can be gleaned from what is happening in Greece.  In short, Greece needs to restructure its debt; in other words, it needs to default.  However, global banks and investors (take your pick) that speculated in credit default swaps, and international institutions (IMF, central banks) intend to do whatever it takes to prevent Greece from formally defaulting. The most recent ploy is to frame a default as a “voluntary exchange;” doing so is deemed to not trigger a payout by the sellers of CDS.  However, a sovereign nation has no reason to play semantics with how it defaults, and is not beholden to sellers of CDS…unless there are implied threats against the country for doing what is best for its citizens.

So, as indicated in the blog by Automatic Earth titled “Honey, I Swapped the Greeks,” the concern is not with Greece defaulting and reducing the principal due to bondholders.  Instead, the concern is with the huge payouts that would be required by CDS sellers (think insurance companies and banks; hedge funds; holding companies like Berkshire Hathaway; et al.)…and the money is not there to payout.

                  Total Greek bond notional CDS: $5.4B 

                  Total Greek bond market: $374B

                  Total Greek CDS market: $455B (ergo the problem with a formal default)

And, if Greece proceeds to formally default and not engage in semantics, then one can estimate the carnage from contagion of CDS payouts as defaults spread to larger sovereign nations that are in similar financial straits…

UPDATE: 20 June 2011.  (*) Note: Bloomberg's values in chart, and figures highlighted in article do not sync.  It appears one of the sources does not use the appropriate currency.  The magnitude, ratios and schedule are apparent regardless. 

Below is a mini-curation of a few interesting articles addressing Barriers to Entry, Shorting Restaurant Chains, Keynesians, and our Emerald City - Seattle: