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The Risk Telescope — The Day After

Sun, 11 Mar 2012 15:39:50 GMT

A collective sigh of relief is nearly audible this weekend.  At least one set of contractual obligations (credit default swaps) will be honored on time, in full, and in the manner anticipated when the contracts were written.  The months-long anticipation of this event, paired with generous (3-year) bank liquidity support by the European Central Bank and the direction of official sector support for European banks through the second bailout for Greece, means that paying out on these contracts will not be as catastrophic as would have been the case last year.

The largest sovereign default in history was paired with a functioning market mechanism in the OTC derivatives space, supported by a wide range of direct and indirect official sector support.  Contemplate this Sunday afternoon the extreme irony and inherent contradictions of the situation.  This is not a sustainable or solid foundation.

  • Global policy initiatives within the G20 since 2008 have all pointed in the direction of vilifying destabilizing and volatile OTC derivatives markets.  Yet those markets served their function on Friday with comparatively less drama than their official sector counterparts.
  • Global initiatives within the G20 since 2008 have all pointed in the direction of vilifying policies that enshrine or promote “too big to fail” in the banking system.  Yet the ECB’s LTRO and the second Greek bailout suggest that this policy is alive and well in Europe.  This suite of crisis management tools seems likely to be endorsed by the global community through IMF participation in the second Greek bailout this coming week.
  • Arguably, markets had the space in which to maneuver and declare a “credit event” had occurred regarding Greek CDS instruments because central banks in Europe and the United States are providing unprecedented, unconventional, and open-ended support for financial markets which lengthen maturities and twist traditional mechanisms for formulating and executing monetary policy.

Relief that any market mechanism functioned as intended is rational.  But as we turn to face the post-LTRO, post-CDS credit default world, it would be better to focus on the related risk management and strategic issues that remain on the table, unresolved, at the G20, the IMF, and Europe.  This issue of The Risk Telescope thus focuses on the risk pricing, collateral management, and risk modeling implications raised by the new status quo in Europe.


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