Monday, June 27, 2011

The insanity of demagogy

Recently the Greek media have witnessed a bizarre and unusual case of 'tabloid breaking news', whereby an elected member of the Parliament (from ND, the right conservative party Nea Demokratia), Panos Kammenos, accused the current PASOK Prime Minister George Papandreou for involvement in a highly abusive 'inside information' case of financial fraud in which the PM 'allegedly' must have indirectly used CDS trades to enrich himself and his family. I initially heard this from a friend whose spouse went ballistic at the break of the story. Then, I read related Internet press articles and blogs to find out more. Kammenos's intent was to obviously lead the chaotic Greek Public opinion to the belief that PM George Papandreou 'sold' the country to 'money-makers' for the sole purpose of his own personal wealth. That was the biggest pile of bullsh#t I heard in recent years. Kammenos's story was manufactured so badly that even a ten year old with elementary knowledge of arithmetics, if properly explained simple CDS rationale and mechanics, would have told you the story was totally crap! Worthless to even be called 'news' whatsoever! I heard Kammenos repeat his incredibly idiotic arguments on the radio too, interviewed by Hatzinikolaou, a right wing reporter, who nevertheless seemed quite irritated by what he was hearing. Nevertheless, the entire nation, currently depressed by troika's (EU Commission, ECB, IMF) austerity measures, initially believed (and many still do) this incredible sample of populism and mean demagogy. In every country I know there are always elected parliamentary representatives, who make a habit to go after 'conspiracy theories' of all sorts, and emerge as master populists, mostly in their own personal interest in acquiring extra future voters. Bizarrely, they all seem to envy the infamous glory of Wikileaks founder Assange, I reckon.

OK, that's the story. The way I understand it, and in a language that I'd use to explain to eight year olds, here are the facts that have been reported in the press and blogs.

In the summer of 2009 under the Conservative government of PM Karamanlis, the Post Office Bank in Greece (TT) purchased a number of CDS contracts to cover a financial risk of approximately one billion dollars. What does this mean? I believe the TT must have owned a whole lot of Greek Treasury bonds. Fearing potential loss of cash in case of a credit event (i.e. sovereign bankruptcy, debt restructuring, and more like that) the TT general management at the time decided to cover their exposure for one billion dollars. Why just one Billion? Why not two or more? Well, the way to cover this type of risk is via the so-called Credit Default Swaps, or CDSs. CDS work kinda like an insurance policy. They cover a financial risk amount (in the case of TT a Billion dollars), they expire like bonds at a predefined maturity date, and cost a premium that is known as the 'spread'. The spread is paid quarterly to the seller (or, say, insurer) and it is measured in basis points (one basis point is 1/100 of one percent of the 'nominal' risk amount that the CDS covers). In the case of TT, I estimate the spread must have been in the region of 100 to 130 basis points (1 to 1.3 percent - I base my assumption on historic graphs that I found about CDS spreads for Greece and a bunch of other Euro-countries in the last 3 years). This means that, in order to cover their one Billion dollar risk exposure, TT would have to pay an annual fee of about 10 to 13 million dollars to Goldman Sachs (if I remember well, GS has been mentioned as the issuer/seller of those CDSs). Were the nominal (exposure) amount 2 or 3 billion dollars, they (TT) would then have to pay 2 to 3 times the mentioned spread (in the region of 30M dollars annually). The more risk you cover the more it'll cost you. But you need to own the cash to fulfill the spread paying requirement. You don't need to be a brain surgeon to grasp this, right?

One thing you need to remember: CDS are contracts that don't individually cost you anything per se at the time of issuance; you just agree their terms and conditions and sign the bloody thing. Like insurances though, you are next required to pay annual premiums (the spreads), moneys that could eventually disappear entirely into the insurer's pockets as plain and pure profit (like it almost always statistically happens in the Insurance Industry). The TT managers bought the CDSs in August 2009 simply to be able to sleep on 'both their ears', as we often say in Belgium. That is, they did that trade to feel 'safe' even if a catastrophic event happened before the CDS's maturity. (As already mentioned, this event happened in the summer of 2009. During the last days of the Conservative government. For a country in disarray the absolute fee amount payable to GS by TT was pretty substantial. I wonder whether TT makes a habit of covering their exposures via CDSs. Or, were any 'usual' kickbacks involved, like the common practice goes in Greece? Who knows. Nothing surprises me anymore...)

In conclusion, during the summer of 2009, the TT leadership believed their Nation's Government was at risk of defaulting on their public debt. And they thus decided to cover their 'derrière', pardon my French. That decision was to cost TT about the best part of 10 to 12 M dollars a year (like I said earlier, I didn't find mention of that particular transaction spread anywhere, I just base my assumption on graphs that I found of the Greek CDS spreads at the time - mind you, same Greek spreads now, mid-2011, are about 20 times as high!). TT engaged in financial risk coverage for one billion dollars that cost them between 10 and 12 million dollars per annum, I'll say this time and again. In case of no credit events until expiry, all these moneys would have gone away from TT's (and Greek taxpayers') pockets into the pockets of big-ass bankers of Goldman Sachs, bless their soul.

Later that fall, early winter 2009, and following fresh Parliamentary elections, the Socialist PASOK returned to power, with George Papandreou as the country's new PM. A little later, in December 2009, TT decided to ditch the August CDS contracts. I guess, the new government was trying to save money on anything that moved, and the new TT leadership kinda thought, "why the heck do we need to hedge that Billion dollar risk? We need to save money and cut cost wherever possible. Why then continue to pay 12M a year to someone like GS? Let some others, who fear Greece's default even more, go buy CDSs from Goldman. Let them pay GS the spreads instead." Here's where this gets interesting: Per Kammenos, the new parties, who emerged as buyers of those same CDSs and that for a spread of 130-140 basis points, presumably were what is known as 'naked CDS' traders. Meaning, they owned no underlying securities (risky bonds) to hedge against. They just did the trade hoping to earn easy future money by playing on spread variances when the latter would have climbed recklessly. Kammenos mentioned a couple of company names (I don't believe he could prove that with hard evidence yet, and I guess it's pretty hard to do this anyway), and via some shrewd populist wizardry he managed to implicate PM Papandreou, and accuse him of indirect involvement in the CDS sale to those companies. In fact, Kammenos said that relatives of Papandreou (his brother Andrikos) had an indirect connection with one of the companies that purchased the CDSs via a member of the Board (ex President of Costa Rica) sitting on both companies, the buyer and Andrikos's (Jeez, like this you can prove Obama's dad assassinated Marilyn Monroe to spare JFK a scandal). Then Kammenos jumps into the stratosphere and mentions a couple of figures that could award him the Guinness Book of Records prize for Populism 2011! He mentions that in this transaction TT lost a total of 40M dollars potential profit (and he insinuates at the same time that PM Papandreou's friends at TT gave that profit away to his relatives and friends in the purchasing companies). Kammenos then ejects himself into the outer space and claims that these same CDS are now worth 60 to 65 Billion dollars (give and take a few billion, no shit)! OMG! And that PM Papandreou is the next one to emerge in the top 100 Forbes list of richest people on planet Earth. Welcome to the club of the rich and famous, Georgie boy! You actually made it this time, dirty devil. Poor sod Panos Kammenos just squared the circle, folks! Right on...

I guess Kammenos doesn't even know what a billion dollars looks like. For sure he's got no clue how many zeroes that is. I guess as many as he got in his math test when he was at junior high. But, I don't wanna sound speculative and populist myself. I will simply prove, based only on definitions, average level of human logic, and simple addition and subtraction that Kammenos qualifies to be a member of Anti-Mensa, involving people with single digit IQs. Yes indeed.

Let's see what CDS speculators normally do (whatever I say here is explained in spades in the CDS Wikipedia article and other relevant sources... I din't make this up, me!) A speculator who trades on the back of risky sovereign debt, and expects CDS spreads to climb, enters a buy transaction early enough when possible. In Greece's case, someone with a clear vision about what could happen in 2010 and 2011, and a hell lot of money in his/her pocket (only big dogs can play this type of market), could have entered a CDS 'buy' transaction sometime in 2009.  From this perspective, the TT leadership (albeit no speculators, I presume, but one never knows in Greece) proved quite visionary in their investment activity during August 2009. Sort of.

What happens next? Well, after they bought CDSs, speculators will have to start paying the quarterly spreads due to their suppliers. For a Billion dollars those quarterly payments are in the millions. That's why CDS speculators have to be 'big dogs'. They are cash rich and can spare to pay 10M a year for a 'normal' spread of 100 basis points on a nominal of one Billion, waiting for the sun to shine on them. These are people (companies, hedge fund managers) who can afford to hold their 'cash' breath for a very long time. And hope for the best (eh.. worst in fact, as far the sovereign debt is concerned). If spreads start climbing, then two things may happen: CDS traders, while holding to their old 'CDS buy' contracts, will a) either sell new CDS contracts for the same nominal amount at the current much higher spreads, or b) simply do nothing and wait for spreads to climb even higher.

Note: Those institutional investors with underlying dubious securities in their portfolios, who risk losing considerable value in case of sovereign default, will normally stick to their CDS and won't sell them back-to-back to 'play' the spreads... they'll just use CDSs like anybody who insures his house or car against potential damage. Kinda like TT should have done if they felt high risk in their holdings of Greek sovereign debt. In other words, normal investors don't speculate on spreads. Only 'naked CDS' traders should/would normally be interested in taking advantage of climbing spreads. These folks are speculators. They take high risks expecting high returns. Like gambling! The rest of us, like TT for instance, will continue paying spread fees and sleep on both ears regardless of spread climbs. It's in fact quite stupid to even think, let alone claim that TT lost a cashing-in opportunity by selling their CDS early and because they didn't speculate on the spreads. As an organization with State participation, even if they had kept their CDSs, they should have never sold them back-to-back to take advantage of higher spreads. Unless Kammenos claims that his party's conservative leadership advised TT management in August 2009 to speculate (OMG!) on Greece's risk to default its sovereign debt! That would make them ND cabinet far more guilty that they ever thought possible. With Kammenos carrying their flag, marching proudly to the abyss.

What is this spread trading by speculators good for, then? Well, if you own CDS that you bought at low spreads and decide to sell them back-to-back when spreads get higher, you can earn the difference as pure profit. If the spread delta is, say, 500 basis points, this would yield 50 million dollars in a year's time on a nominal of one billion dollars. Capice? Now, how likely are spread deltas that high? In the case of Greece very likely. Right now the delta between what TT agreed to pay in August 2009 and what is traded in our days gets to the best part of 2000 basis points, or 200 M dollars a year. Pretty much insane, innit? However, the total amount of spreads you get from your buyer (client) until CDS contracts expire, minus the total spread amount you paid to your seller (supplier) over the same period may turn to be either positive (profit) or negative (loss). Now, if you rush and sell back-to-back your purchased CDS soon after you bought them, the delta between spreads is probably small; however, you can pocket this delta over a longer period of time until expiry. If you wait and only sell them when the spreads got real high, then you'll be pocketing a larger delta but for a shorter period of time. This is the point I have been trying to make all along. Not only the suggestion that TT had to speculate with CDSs to benefit from spread variance profits, but also the 40 M opportunity Kammenos mentions is absurd beyond belief. Where did he come up with this figure? What assumptions did he make? Suppose TT didn't sell its CDSs in December 2009. When were they then supposed to sell them to enjoy a delta (how many basis points would that be?) that over time would have earned TT the famous 40M? And where does this 40M come from? Is it the lost TT profit opportunity to this day or does it include amounts that TT could have potentially gained until the CDS maturity. And what if a credit event happened tomorrow? How much would then be TT's loss, since their speculative trading would have deprived them from the right to benefit the payout of their original Billion dollar exposure? All these play quite a role in defining potential profits or losses. What is Kammenos really talking about here? Looking at the graphs, I betsa, if TT was run by speculators, and behaved like I explained above (which I guess they are not supposed to be doing with taxpayers' money anyway) they could have made to-date anything between a loss of 20M to 60M profit or more. 40 million profit represents just a spread delta of 400 basis points paid over a year. Kammenos's wishful thinking. But we are almost two years later now! In the meantime CDS spreads in Greece have grown to 2000 basis points. Kammenos is really a dick in simple arithmetics and launched a 40M dollar speculative amount all over the map. There's no way to define that amount at all! Scientifically impossible to calculate. Because any assumption made by Kammenos is as good as any other made by you or me for that matter. And each assumption leads to  a final P&L bottom-line that could equally probabilistically be either negative or positive. If we knew how to make a P&L positive in speculative trading we would all be rich by now. Do you get it, Panos dude? I seriously doubt it!

Next, I don't wanna waste much more of my energy and your time in responding to the 65B dollar BS innuendo like Georgie P., the PM, and his friends have potentially earned and are worth today per Kammenos allegations! In this particular case a CDS contract covering one billion dollars risk may have been priced at any spread between 100 basis points and 2000. If a credit event happened before the CDS's expiry, this is all you get, provided you own and have always meticulously paid all of your spreads: Just one Billion. Now, like I said, to ever get this Billion the underlying security (the T-Bill) must somehow default (sovereign bankruptcy, inability to pay at all or debt restructuring) before expiry of the CDS contract. CDS spreads continuously change to reflect increased default risk. A bond owner, worried about losing an investment of a Billion dollars in Greek sovereign debt is nowadays paying 200M dollars a year as insurance premium (CDS spread). If disaster then strikes before the bonds' expiry he'll eventually receive the principal minus 20%, which is still a hell lot better than kissing the entire billion good bye. Pretty insane spreads to pay, but still the decision to keep paying them if the risk is real makes a lot of sense.

The 60 to 65 Billion multiple 'worth' Kammenos came up with of the one Billion dollar initial nominal amount... what can I say? Where did Kammenos pick this up from? Did he think that money is created out of hot air that he currently breaths as we speak in the heat wave my compatriots are currently experiencing from the high North to the deep South? Maybe. Well, as a final remark to that moron: Even my grandma knows (RIP) that the Billion dollar nominal amount of this transaction could never ever become anything more than 1B, let alone 65B. The contracts mention 1B in case of default. That's it. Pretty good dough, but still far, far and away from Wall-e Utopia land inhabited by Kammenos and those who use him to spread conspiracy BS (BTW, 'Kammenos' means 'burnt' in Greek, no shit)!