The CDS market and Greece’s default

By Felix Salmon
July 22, 2011

ISDA has made the right decision: the Greek bond default does not and should not count as a “credit event” for the purposes of whether Greek credit default swaps will get triggered.

This is the right decision for two reasons. Firstly, the swap is voluntary. If you don’t want to suffer a haircut, or see your six-month maturity suddenly become a 30-year maturity, then all you have to do is nothing. If the CDS paid out, that would be tantamount to giving free money to anybody who wanted it: just buy short-dated Greek debt and also credit protection on that debt. The bonds will pay out in full, and the CDS would pay out as well.*

Secondly, this should be a large nail in the coffin of the CDS market generally. Credit default swaps were designed primarily for banks: it took many years before they became widely-traded speculative instruments in their own right. The idea behind them was that banks could keep loans on their balance sheets while at the same time hedging the risk that they would default. That was easier and cheaper than selling the loans outright, and also helped banks maintain good relations with their borrowers.

In the case of Greece, however, banks are going to take a 21% haircut on their loans to the country — and if they hedged themselves in the CDS market, too bad. Whatever they paid for their CDS protection — and if they bought it recently, it could be quite a lot of money — will not help them one bit. If buying CDS doesn’t help you in the event of a default, then there’s really no point in buying CDS.

So even though there isn’t going to be a formal credit event in Greece, have no doubt that this is a default — or, at least, that it will be a default if the banks are correct in anticipating a participation rate of 90%. But I have to say I’m surprised they’re so bullish, and I will be extremely impressed if Greece wakes up one morning to find that 90% of its private-sector debt has been tendered into the exchange.

For one thing, the exchange is structured in a pretty unsophisticated way. No matter whether you have a bond maturing tomorrow or a bond maturing in a decade, you’re swapping it into exactly the same 30-year instrument. Banks with short-dated Greek debt aren’t going to be happy about this, and will have a strong incentive to quietly sell that debt on the secondary market to someone willing to just hold it to maturity.

And more generally, it’s almost impossible to see why anybody who isn’t a bank would tender into this exchange. If you’re an individual holding Greek bonds, or a big bond investor like Pimco, the obvious thing to do is to hold on to your debt for the time being, since the exchange includes no carrots and no sticks. The only incentive for you to tender into the exchange is that the new bonds will be partially collateralized with zero-coupon 30-year bonds. Triple-A-rated 30-year bonds in euros currently yield 4%, which means that the collateral in the new Greek instruments will be worth less than 31 cents on the dollar. And so far, there’s been zero indication that holdouts will get anything less than all their money back, in full and on time; they might have a bit less liquidity, but bond investors are used to illiquid instruments.

Is it really the case that over 90% of Greek bonds are held by banks which will tender all of their Greek debt into the exchange? Maybe so; non-bank investors looking to go long Greek credit might well have found it easier and cheaper to do so by writing credit protection in the CDS market rather than buying cash bonds. In which case they’re smiling broadly today.

If that’s the case, then maybe this deal is one of those rare occasions where the CDS market was genuinely useful. Back in the 1980s, when sovereign debt was held overwhelmingly by banks, negotiations about restructuring that debt could be held with the London Club of bank creditors. Non-bank investors didn’t really matter. But then the loan market became a bond market, and investors in sovereign debt were mainly non-banks; no longer were negotiations even really possible.

Now, however, we seem to have come full circle: banks are able to put together bond-restructuring deals on their own, without worrying much about non-bank bond investors. And one reason would seem to be that the non-bank investors have largely moved from the bond market to the CDS market.

Is this scheme going to work? There’s a big collective-action problem at the banks, and an even bigger problem with the non-banks. So the 90% target is ambitious. But so far I haven’t seen much doubt. I will say this: if the 90% target is achieved, then the Institute for International Finance will deserve a lot of credit. I’m no fan of the organization — I’ve been very rude about it for many years. But if it manages to pull this off, it will finally and genuinely have justified its existence.

*Update: Kid Dynamite asks a good question in the comments: if the bonds paid out in full, wouldn’t the CDS auction clear at par, with the CDS paying out nothing? No. To a first approximation, the CDS auction clears at the price of the cheapest-to-deliver Greek bond, and Greek bonds are trading at a substantial discount. The cheapest-to-deliver bond will probably have a very long maturity, and if there was a credit event for CDS purposes, then holders of credit default swaps would get a nice check in the mail.


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