Surprise! The details underlying gross exposure is relevant in assessing risk as value of CDS hedge is questioned

In her Financial Times column, Gillian Tett looks at credit default swaps.  Specifically, she asks the question if the 50% write-down on Greek debt is not enough to trigger the related CDS, then what good are CDS as a hedge.

Not very and as a result, it is the details underlying gross exposure that is relevant for assessing the risk of the banks.  Particularly, the large banks in the US that have $5 trillion of exposure.

Regular readers know that banks should be required to disclose this information on an on-going current basis.

Earlier this year, Deutsche Bank quietly decided to reduce its exposure to Italian government bonds. But it did not do that by simply selling debt; instead it achieved this partly by buying protection against sovereign default with credit derivatives contracts.... 

But there is a crucial catch. These days, it is becoming less clear whether those sovereign CDS contracts really offer effective “insurance” against default. And that in turn raises a more unnerving question: if the exposures of the large European banks were measured in gross, not net, terms, just how much more vulnerable might they be to sovereign shocks? 

Or, to put it another way, could the problems now hanging over eurozone banks and bond markets be about to get worse, due to the state of the sovereign CDS sector? 

The issue that has sparked this debate is, of course, Greece. In October, eurozone leaders announced that they intended to ask investors to swap any holdings of existing Greek sovereign bonds for new bonds, with a 50 per cent haircut. Logic might suggest that a loss that painful should count as a default. If so, logic would also imply that it merits a CDS pay-out. 

After all, the whole point of credit derivatives – at least, as they have been sold to many investors in recent years by banks’ sales teams – is that they are supposed to provide insurance for investors against the risk of a bond default....

But Greece, it seems, is different ... at least, under ISDA rules. When the eurozone leaders announced their plans to restructure Greek bonds they failed to meet – or, more accurately, deliberately missed – the fine print of “default” under ISDA rules. 

Most notably, the standard ISDA sovereign CDS contract says that pay-outs can only be made when a restructuring is mandatory, or a collective action clause invoked. However, it seems that 90 per cent of Greek government bonds do not have collective action clauses; and the October 26 announcement presented the haircut as “voluntary”. Thus ISDA has concluded that “the exchange is not binding on all debt holders”, so the CDS cannot be activated...

Many investors, unsurprisingly, are outraged; some observers, such as Janet Tavakoli, a consultant, conclude that the saga has exposed the CDS market as a sham... 

But the longer that the wrangle about Greece continues, the harder it will be for banks to argue that sovereign CDS is a good hedge for their counterparty or credit risk.

In short, what exactly are the banks' detailed exposures?