CDS conspiracy theory du jour, Gretchen Morgenson edition

By Felix Salmon
November 20, 2011

Why oh why does Gretchen Morgenson insist on writing about credit default swaps as though she understands them? She’s done it again today, with an article about Greece which ratchets the conspiracy theorizing up to frankly bonkers levels:

The money managers with whom I spoke said BNP Paribas seemed to be motivated either by its desire to generate fees from the exchange or, perhaps, by worries about its own exposure to Greece. They wondered, for instance, if BNP Paribas has written a lot of insurance on Greek debt. If so, getting people to unwind such swaps now would be less costly for BNP than having the insurance pay off.

Note the levels of deniability here: if you look at how BNP’s actions “seem” to be motivated, they are “perhaps” being driven by BNP’s own exposure, which could be reduced “if” it has a lot of CDS exposure to Greece. And, of course, the whole thing is wrapped up in its own invisible quote marks — it’s all the opinion of anonymous money managers, without Morgenson giving us any indication at all of why we should be listening to them in the first place, or what their conflicts might be.

(There is actually a truth to the matter, here, as Peter Thal Larsen points out: BNP Paribas had €5 billion of direct exposure to Greek debt at the end of 2010, and a mere €0.1 billion of indirect exposure.)

The other explanation of BNP’s actions in this passage is simultaneously obvious and very weird: the bank, says Morgenson, might be “motivated by its desire to generate fees from the exchange”. Which is pretty much the most prejudiced possible way of saying, simply, that BNP has a job to do, and it’s doing that job.

BNP, you see, has been hired by the government of Greece to gin up interest in Greece’s bond exchange and try to ensure it goes smoothly. That’s a smart move by Greece, because BNP is one of the largest holders of Greek government debt. And this is quite an elegant way of Greece ensuring that BNP, rather than having to be persuaded to go along with the deal, will in fact be trying to persuade everybody else to go along with the deal.

But that obvious and true explanation of what BNP is doing isn’t good enough for Morgenson, who instead indulges anonymous money managers in flights of fancy about how BNP might have “written a lot of insurance on Greek debt”. There’s no evidence for this whatsoever — and I don’t believe for a minute that it’s true. In fact, I can’t think of any bank which has ever amassed a significant long position in any given name, through the CDS market, for any significant length of time. The poster children for that kind of misbehavior were the big insurers, including AIG, who ended up with long positions in highly-bespoke CDS. The closest thing I can think of at a bank was Howie Hubler’s disastrous mortgage-bond trade at Morgan Stanley, where a relative-value play blew up in his face. But the one thing all those blow-ups had in common was that their long position was in super-senior debt which was considered ultra-safe.

And in any case, if BNP had indeed written a lot of protection on Greece, it’s very hard to see how (a) it could manage to get the Greek government’s mandate because it had that position; or (b) how having the mandate would actually help the bank at all with respect to its position. Morgenson makes a very big deal out of the fact that one of the BNP bankers — Belle Yang — is on ISDA’s determinations committee for Europe, and can therefore help influence whether Greece’s CDS pay out or not — but that would be the case whether or not BNP had the mandate.

What’s more, Morgenson is objecting to some extremely unexceptional statements by Yang. Here’s Morgenson:

The BNP Paribas bankers have been telling bond holders that their credit insurance may not pay off down the road, because after the restructuring is completed, the terms of the old debt might be changed, these money managers said.

Normally, investors would shrug off such an argument…

According to one of the money managers, Ms. Yang told the investors that one potential hitch would be if Greece were to change the terms of its old bonds…

If investors think debt terms can be changed by fiat, they will flee the market. Ditto if they find that their insurance can be made worthless. Indeed, some of the volatility in European debt recently may be attributed to investor fears about these issues.

Morgenson’s saying, here, that it’s unthinkable for Greece to unilaterally change the terms of its old bonds, and that no one even considered such an eventuality until recently, when “some of the volatility” we’ve been seeing of late might be a result of investors suddenly realizing that it’s possible and that one of the ISDA committee members might somehow allow it to happen.

This is ludicrous. Everybody knows that Greece can and should take some kind of tactical advantage of the fact that most of its debt has been issued under Greek domestic law. Never mind the fact that a BNP banker sits on an obscure ISDA committee: why not look instead at what’s been written by the dean of sovereign-debt lawyers, Lee Buchheit, on this very subject? Buchheit works for Cleary Gottlieb, and is working directly for the Greek government. And more than 18 months ago he laid out Greece’s options very clearly, in a paper which was posted freely on the internet and which has been downloaded thousands of times, not to mention being passed around in PDF or printed-out form to pretty much everybody who’s involved in making decisions about Greek bonds. Yang, it turns out, was saying nothing which Buchheit wasn’t saying in May 2010:

The greatest advantage that Greece would enjoy in a restructuring of its debt derives from the fact that so much of the debt stock is expressly governed by Greek law. This raises the possibility, discussed in more detail below, that the restructuring could be facilitated in some way by a change to Greek law…

International investors are often leery of buying debt securities of emerging market sovereign issuers that are governed by the law of the issuing state. Why? Because investors fear that the sovereign might someday be tempted to change its own law in a way that would impair the value or the enforceability of those securities. Such changes in local law would normally be respected by American and English courts if the debt instruments are expressly — or otherwise found to be — governed by that local law.

Buchheit proposes one action that Greece could take — a “Mopping-Up Law” which would essentially change the payment terms on untendered bonds so that they were the same as the payments being received by bondholders who tendered into the exchange. There are many others: a sovereign country can change its own law pretty much any way it likes. And although there would surely be legal challenges if it tried to do so, I don’t think there’s anybody who’s optimistic such challenges would succeed.

If there were any investors out there, 18 months ago, who didn’t realize that Greece’s debt terms can be changed by fiat, there weren’t any after Buchheit’s paper came out. So when Morgenson says that investors “will” flee the market when they work this out, she’s at least 18 months behind the curve. And indeed one of the big reasons why Greece’s debt is held overwhelmingly by banks rather than by institutional bond investors is precisely this one.

More generally, Morgenson’s simply wrong when she says that the treatment of CDS is a “a big point of contention” in this restructuring. She’s been talking to an unknown number of “investors” and “money managers”; the only one she names is David Kotok, of Cumberland Advisors. But as everybody involved in the Greece deal knows, institutional investors in general, and American institutional investors in particular, are essentially an afterthought here; the deal will succeed or fail based entirely on the degree to which it’s embraced by Europe’s banks.

The funniest part of Morgenson’s article is this:

Investors who own Greek debt and have bought insurance on it, in the form of credit default swaps, wonder why they should accept the offer that’s on the table…

The discussions with BNP Paribas confirm the view of some investors that credit default swaps are not insurance at all.

Does Morgenson really believe that CDS is an insurance product and used that way by investors? That there’s a bunch of bond investors out there who bought Greek bonds, and then, rather then selling those bonds, bought protection on them instead, using that protection as insurance against a bond default?

The truth of the matter is that the set of “investors who own Greek debt and have bought insurance on it, in the form of credit default swaps” is utterly minuscule, and that every single member of that set is a highly sophisticated player who knows all about issues surrounding Greek domestic law and the potential problems with this kind of basis trade. The last thing that any of them need or want is Gretchen Morgenson going to bat for them on the front page of the Sunday business section of the NYT. And their plight is certainly not of interest to the NYT’s readership as a whole.

Update: Just when you thought this whole thing couldn’t get any sillier, it now emerges that BNP might not actually be advising the Greek government after all! Athens News reported on November 6 that Greece “has terminated its collaboration” with BNP, Deutsche Bank, and HSBC.

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