A 70% Haircut is NOT a ‘Credit Event’

Officials Rule No Payout on Greek Swaps

By PETER EAVIS, The New York Times

March 1, 2012, 8:24 am

During the financial crisis of 2008, derivatives contributed to the mess. Banks feared that their trading partners might not make good on their obligations, a situation that panicked the markets and nearly brought the financial systems to its knees.

As part of Greece’s restructuring, bondholders will be required to take a 70 percent loss on their holdings. When first announced, the deal was proposed as a voluntary exchange, which would not have activated the credit-default swaps.

But in recent weeks, Greece has prepared to require all private bondholders to accept the losses through legal means. This would make the exchange involuntary and almost certainly set off the swaps.

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One question the process faces is whether committee members will vote according to their economic interest. Many of the banks on the committee have recently reported substantial exposure to swaps on Greek government bonds. For instance, Barclays, which voted against swaps activation on Thursday, had sold default protection on $5.92 billion of swaps on Greek debt, and bought $5.81 billion of protection, as of Sept. 30 last year, according to the European Banking Authority.

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Even so, the ruling – and the prospect that Greece could default without activating the swaps – could reignite the debate about the usefulness of the financial instruments. If borrowers can structure defaults to circumvent swaps payouts, investors may see the swaps as unreliable.

“The market has been harmed by people playing games to avoid events that would be covered by the insurance,” said John Sprow, chief risk officer at Smith Breeden Associates, a fund management firm.

As Felix Salmon points out, this could very well destroy the Credit Default Swap Market-

Understanding Greece’s default

By Felix Salmon, Reuters

March 1, 2012

At the WSJ, for instance, the news story on today’s official ISDA determination (“Greek Deal Won’t Trigger CDS Payouts, Panel Says”) is bad; the blog post about it by Charles Forelle (“ISDA’s Greek Ruling Not the Last Word”) is very good.

And in Europe, the range of sophistication within policymaking circles is even greater. At the lowest, most basic level, one finds a feeling that it’s a Bad Thing if a European sovereign nation were ever to default, and so therefore it would be a good thing if the bond exchange was organized so that there was no official market determination of default. (Never mind that Greece is already in selective default on its bonds, according to S&P.)

At a slightly higher level of sophistication one finds the short-sellers-are-bad crowd, who don’t like CDS because they allow hedge funds to easily bet against countries. If the messy Greek CDS situation helps to reduce the amount of trust that the markets have in sovereign CDS generally, then so much the better, on this view.

And then, finally, there’s Peter Eavis’s conspiracy theory: if the Greek bond exchange goes really smoothly, and the sun rises in the morning and Italian bond yields stay below 5%, then maybe that’s the most worrying outcome of all. Because at that point Greece will have managed to wipe out, at a stroke, debt amounting to some 54% of GDP. You can see how Portugal and Ireland might be a little jealous. You don’t want to make sovereign default too easy – not least because it would do extremely nasty things to European banks’ balance sheets.

That said, Greece has now broken the sovereign-default taboo; many countries both inside and outside Europe have way too much debt; and now that debt relief is an option for politicians to seriously consider, it’s pretty much certain that at some point another European government will end up choosing that option.

How Greece’s default could kill the sovereign CDS market

By Felix Salmon, Reuters

February 29, 2012

In the best-case scenario for Greece and Europe and bondholders, every €1,000 of old Greek bonds will get converted to new bonds with a face value of just €315. Those bonds will probably trade at about 30% of face value, which means the new-Greek-bond component of the exchange will be worth about 10 cents for every dollar in face value of old Greek bonds that you might currently hold. Add in another 15 cents of EFSF bonds, and the total value of the exchange will be about 25 cents on the dollar, which is why people are talking about a 75% “present value haircut”.

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The way that CDS auctions are meant to work is that once a borrower defaults on its debt, that defaulted debt continues to be traded in the market, and its value then determines the amount that credit default swaps need to pay out. But in this case, Greece’s defaulted debt might well not continue to be traded in the market. In which case, when traders need to find a cheapest-to-deliver bond to bid on in the CDS auction, they’re going to have to use one of the new bonds, rather than one of the old ones.

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In other words, Greece’s CDS really aren’t protecting holders of Greek bonds at all – or if they do, it’s more a matter of luck than of law. When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds.

What this means is that the CDS architecture is broken, and can’t cope with collective action clauses. And as a result, according to the hedge fund manager who tipped me off to the whole problem, “this Greece CDS imbroglio might be the final blow for sovereign CDS as a product.”

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The whole point about credit default swaps is that they’re meant to behave in a predictable manner in the event of default; one thing we know for sure about Greece is that the behavior of its CDS is going to be anything but predictable. We don’t even know for sure whether they’ll be triggered, let alone what they’ll be worth if and when they are.

Now there are a lot of people, among them European policymakers, who would actually be quite happy if the Greek default killed off the sovereign CDS market as a side effect. But I actually believe that sovereign CDS, when they work, are rather useful things. It’s just that Greece is having the effect of showing that they don’t necessarily work. And if you can’t be sure that they’ll work when triggered, there’s really no point in buying them at all.

Since a majority of CDSes are issued by banks and they collect substantial fees for them, they may have just killed off the goose that lays their golden eggs.