The $41Bn Fiasco by Russia and the Credit Default Swaps
How Western Sanctions on Russia can trigger the Global Financial Crisis?
Russia is witnessing the fourth financial crisis in 25 years.
1998–99 — Russia Defaults on Debt
2008–09 — Russia invaded Georgia
2014–15 — Annexes Crimea
2021–22 — Russia invades Ukraine
After Russia invaded Ukraine, the Global Economy has witnessed the worst of the crisis:
→ Russian stocks listed on London Stock Exchange collapsed by 99%
→ Russian Ruble is down 50%
→ Brent Crude Oil is has rallied from $85 to $140/barrel
→ Russia’s 5-year credit default swaps are at an all-time high which can cost up to $41 Bn to the Global Economy
Credit Default Swaps & 2008–09 Financial Crisis
In this article, we dive into Credit Default Swaps.
Credit Default Swaps (CDS) are financial agreements wherein the seller of the swaps agrees to compensate the buyer, in the event of debt default. It’s like insurance, which the lender buys to protect himself from the borrower’s default.
Back in 2008–09, when the Housing Bubble Crisis shook the credit market, few smart people used CDS to make billions from the market collapse.
For instance, Michael Burry, An American investor, predicted the housing bubble crisis where housing loans were offered to the large masses without a proper credit check.
Banking houses like Bear Sterns, Goldman Sachs provided these housing loans with money raised through issuing bonds to investors.
Michael Burry did some data crunching and came to a thesis that most of the house owners who borrowed money lacked credibility, which means they will never pay back their loans.
If the loan itself is not repaid, how would Goldman Sachs ever redeem those bonds?
So Michael Burry approached Goldman Sachs and other investment firms to sell him “Credit Default Swaps”, a derivative instrument whose prices will rise in the event banks defaults in the redemption of those bonds.
These “Credit Default Swaps (CDS)” are like present-day options contracts like Call Option and Put Option. In order to buy them, the buyer needs to pay a premium (like insurance premium) to banks.
Settlement of CDS
CDS is mostly cash-settled.
For example, a hedge fund has bought $5 million worth of protection from a bank on the senior debt of a company. This company has now defaulted, and its senior bonds are now trading at 25 cents on the dollar. The market believes that senior bondholders will receive 25% of the money they are owed once the company is wound up (all the defaulting company’s liquidable assets are sold off). Therefore, the bank must pay the hedge fund $5 million × (100% − 25%) = $3.75 million.
If the bank lacks sufficient cash to pay CDS holders then the bonds against which CDS were bought are sold off via auction and CDS holders are paid off.
Till that time, no one has ever imagined that people will default on their housing loans.
Hence, when the crisis broke out and banks defaulted, Michael Burry sold off his Credit Default Swaps and made a profit of $800 Million or 500% of the invested capital.
The cost of insuring debt through CDS contracts is on a steep rise.
With Russia, the CDS contract insuring $10 Mn bonds for 5 years is priced at $4.6 Mn plus $1,00,000 in the annual fee.
This means investors will lose 50% of the bond amount being the cost of insuring debt, in case they wish to insure against Russia’s repayment defaults.
Also, the western countries have imposed financial sanctions on Russia, which means countries have been prohibited from holding Russian Sovereign bonds.
This means the CDS options holders will not receive any money if Russia doesn’t pay them, since the Russian bonds cannot be auctioned in the international markets, because of a lack of interest from global investors.
If this happens, $41 Bn worth of CDS contracts can be rendered worthless.
The crisis is much bigger than we can imagine.
Hope it makes some sense.
