Why the Greek CDS market is OK

By Felix Salmon
October 28, 2011
talk about sovereign CDS of late -- pegged off the fact that the Greek restructuring might not trigger an event of default -- is I think missing three big points.

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All the talk about sovereign CDS of late — pegged off the fact that the Greek restructuring might not trigger an event of default — is I think missing three big points. First, why ISDA’s rules make sense. Second, why Greece’s CDS spreads are still extremely wide. And third, what sovereign CDS are used for.

But before we get to any of that, it’s important to understand the big picture. Greece has a lot of private-sector debt; most of it is held by banks. There is a small amount of sovereign CDS outstanding, which references that Greek debt. To give you an idea of the orders of magnitude here, we’re talking about roughly €200 billion in Greek bonds, and less than €4 billion in net CDS exposure. Even if all of the net CDS exposure was held by bank creditors, it wouldn’t remotely offset the write-down they’re going to have to take on their bonds.

In reality, the banks have de minimis net CDS exposure. They might trade the CDS, and have either a long or a short position on their trading books at any given time, but they’re not using the CDS to hedge their bonds.

Those bonds are freely tradeable: if at any time a bank wants to reduce its exposure to Greece, all it has to do is sell some of its bonds. Doing so would almost certainly involve taking a loss, of course, since the bonds are trading at about 40 cents on the dollar. Which is why the banks are even thinking about accepting an offer at 50 cents.

And in fact, an offer at 50 cents is exactly what Greece is going to give them. Although it’s not really 50 cents in cash; it’s 50 cents in partially-collateralized new Greek debt, which your guess is as good as mine where it will trade if and when any exchange is finished.

The banks may or may not have much of a choice when it comes to accepting Greece’s offer. Some of them are having their arms twisted extremely hard by their respective governments, and feel that they have to do what they’re told. Others are more prone to asserting their independence. Again, it’s going to be a while until it’s clear what the final outcome of any exchange offer will be. But one thing I can guarantee you: there won’t be 100% take-up. In fact, there almost certainly won’t even be 90% take-up. All we know for sure is that if and when this exchange offer comes along, some bonds will be tendered into it, and others won’t be.

Now the way a credit default swap or an insurance contract works is that it’s contingent on some bad event happening out there. If that bad event happens, then you get paid out. The person who owns the CDS or the insurance contract is a passive player in this game — they can’t unilaterally determine whether there’s a payout. So the event of default cannot be a decision to tender a bond into a bond exchange — because that decision is taken not by the debtor but rather by the creditor. Debtors can offer to buy back their debt any time they like, at any price they like. That’s not a credit event, it’s a market.

Now if the offer to buy back the debt is coercive, then things change. But again, the question is who is doing the coercing. Is it the debtor? Is Greece promising to do unspeakable things, under Greek law, to any holders of outstanding bonds who don’t tender into the exchange? Is it threatening to default on those bonds? Is it going to take actions which make the bonds untradeable? If so, then we’re looking at a credit event, since bondholders would be damaged greatly either way.

On the other hand, if it’s France and Germany and other European governments who are being coercive, things change, because the coercion is creditor-specific. It’s in the fundamental nature of bonds that they’re fungible: if we both own the same Greek bond, then anything which is true of my bond must be true of your bond. (I believe this is related to Leibniz’s law of the indiscernibility of identicals, but let’s not go there right now.) France and Germany might be able to twist the arm of BNP Paribas or Deutsche Bank. But if I’m sitting at home in New York with a few Greek bonds in my brokerage account, I’m not going to care very much what Sarkozy or Merkel say. No matter how much they scream and shout, that screaming and shouting can’t constitute a credit event on my bonds.

So let’s wait until Greece does something coercive which seriously damages its outstanding bonds. At that point, we can declare a credit event, and move on.

And that’s going to happen: all you need to do to understand that is to look at where Greek CDS are trading. The tender offer itself might not be a credit event — although it might, if Greece starts larding it up with exit consents and the like. But at some point, there’s going to be a credit event on those reference obligations, if only because no European politician is going to stand for free riders holding on to their old Greek bonds and happily cashing coupon checks at 100 cents on the dollar. Once Greece has swapped out most of its old bonds for new ones, don’t for a minute expect that the holders of the old debt will be free and clear.

And if you want to take the Greek government to Greek court for the money they owe you under Greek law — well, good luck with that. Basically, post-exchange, the cost of default for Greece is tiny. So there’s no reason for Greece not to do it.

Sovereign CDS aren’t dead, then — they just take a little longer to pay out than some people in a hurry might like.

And that’s fine, for the kind of people who actually use sovereign CDS for anything beyond purely speculative reasons. These instruments aren’t used by banks to directly hedge their Greek bond exposure. Instead, they’re used by institutions who are financially exposed to the country of Greece, and who want to hedge their country risk. If you do a lot of business in Greece, or if you have a lot of receivables from there, or if you partner with Greek companies whose failure would hurt your business — then there aren’t many ways of hedging that exposure, but Greek CDS is one of the best of a bad bunch.

Greek CDS is useful even for hedging indirect exposure — a small holding of Greek CDS, for instance, can partially help offset a larger and vaguer exposure to the eurozone as a whole.

And the market in Greek CDS has been pretty efficient when it comes to this role. As Greece has got ever riskier, the price of buying credit protection on Greece has risen, and people owning that protection have made money. That’s the way it’s meant to work.

The only reason that Greek CDS spreads didn’t spike when the latest euro bailout was announced is that they were essentially already pricing it in. If and when Greek CDS spreads come down even as Greece’s creditors are forced to take a 50% haircut, I’ll concede that the sovereign CDS market is broken. But for the time being, it seems to be working OK.

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