In 1975 I took the Dun & Bradstreet Credit Analysis course that all bank loan officers and credit analysts were required to complete. This course covered the fundamentals of analyzing borrowers’ ability to service their debt and the risks associated with their various financial conditions. There were several financial ratios to be calculated and those ratios were compared against industry norms. If an applicant’s ratios were outside the limits, the loan was typically denied. The balance sheet is critical to the financial industry. It is similar to a medical checkup.
Verification of assets and cash flow were fundamental. If there was a mortgage, a statement verifying the current balance was required. A recent pay stub was needed to check the income claimed on the loan application. Each major asset had to be analyzed for it veracity. If it could not be verified, it might be removed from the ratio calculations. The D&B course was used by most banks in the U.S.
What happens if the banks themselves need to borrow money? A similar process occurs by the regulators. If bank ratios become weak, they are put on a watch list. If they become too weak, the regulators find a buyer or shut them down and dispose of the assets.
Now enter the Credit Default Swaps (CDS). What happens if the bank has been issuing lucrative CDS’s as insurance? Initially the bank’s trading department was able to book a sizeable profit with the expectation that those CDS’s would expire worthless and have no balance sheet impact on the bank. CDS’s were issued against European sovereign bonds which have no history of default. This insurance vehicle has been a real money maker for the issuer AND the European Union would come to the rescue of any of its member nations thus eliminating any risk.
Now comes the mismanagement of the Greek economy. Greece has been living on borrowed time and money. There is no realistic way for Greece to work out of its debt without someone taking a “haircut” or loss on the principal of the Greek bonds. A 30% to 70% haircut is now certain. How can the ISDA (International Swaps and Derivatives Association) determine that no default has occurred? Since when does a loss on up to 70% of your principal not constitute a default?
If a default occurs, the insurer must pay up. If the ISDA were to admit to a default, several large international banks would immediately become insolvent. This could trigger a global bank run and take down the current system. There is much at stake with a determination of this nature and the ISDA will resist a default at all costs. Who makes up the ISDA? The very financial institutions and related parties that issue CDS’s. The reality is that when Greece defaults, other weak countries will not be far behind. When this happens, the current financial system’s risk will be greater than the near meltdown in 2008. What is the best insurance against this risk? In my view it is gold and silver. These do not have counterparty risks for man cannot manipulate their value as they do every other financial instrument.
The ISDA may not classify the Greek Bonds as a default, but if it walks like a duck, quacks like a duck…..