Caroline Ritchie: Pass on the credit default swap parcel

It's a new twist on an old market game, and I've dubbed it pass-the-credit-default-swap-parcel.
It relates to Greece.
The most widely reported possible outcome is that should Greece default on its debt, Europe will be decimated while the rest of us just get a diluted financial whipping. In fact, the nation with the most to lose in all this is the USA.
By far the most direct exposure to Greek debt is shouldered by European banks, but thanks to our old friend the credit default swap, these lenders have hedged some insurance against the risk of those bonds imploding.
It works like this: If you lend money - you can also buy a matching credit default swap.
This means that, in the event of your borrower defaulting on you, the person who sold you the credit default swap (CDS) pays you out the par value of your loan. CDS sellers are typically banks and insurance companies.
These sellers take on the risk of the underlying bond defaulting.
Here's where it gets interesting.
A credit default swap is essentially a derivative instrument, and you don't have to be a lender to buy them.
They can be used as speculative plays.
You do have to have fairly large pockets, however, most of these things trade in multi-million parcels.
But the point is that multiple CDS contracts can exist over the same loans.
So, therefore, in the event of default, it's possible that the seller of a CDS may have to pay out many times the nominal value of the loan to holders of the CDS instruments they have sold.
The actual market mechanics get more complicated as you delve in, but the CDS market, like other derivatives markets, is loaded with leverage. Big players take large bets, and when these go the right way (eg. the underlying loans do not default), profitability can be astronomical.
The downside is that when things go wrong they can do so in spectacular fashion and rupture systemically important financial systems.
A lot like the sharemarket, which is an anonymous global call auction, nobody really knows who the buyers and sellers of CDS instruments are until later. All chickens roost somewhere though, and it turns out that America, through the global market of pass-the-traded-instrument-parcel, is exposed to about 80 per cent of a possible Greek default.
That would cause a serious financial wound in itself, but at least the Eurozone would be compensated by their CDS payouts.
At least we hope so. Credit default swaps themselves have been defaulted on before. Remember Lehman Brothers?
Though it is tempting to give Greece a passing glance and pretend that it's all Germany's problem to sort out, we actually need to keep our antipodean eyes well peeled.
The nature of the global derivatives market, which totals over US$600 trillion ($746 trillion) is so enmeshed, that a ruffle of indebted Grecian feathers could lead to a turkey shooting match everywhere else.
Caroline Ritchie is an NZX Advisor for Forsyth Barr in Napier and holds an NZX Diploma, BCom and BSc. For sharemarket advice contact her on (06) 835 3111 or caroline.ritchie@forbar.co.nz.
The comments in this note are for general information purposes only. This article is not intended to constitute investment advice under the Securities Markets Act 1988. If you wish to receive specific investment advice, please contact your Investment Advisor. Disclosure Statements are available on request and free of charge.