How all CDS are at risk of not paying out

By Felix Salmon
March 5, 2012
how Greece's default could kill the sovereign CDS market turns out to have been surprisingly popular, especially among policymakers who are worried about whether there's a serious flaw in the CDS architecture.

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My wonky post last week on how Greece’s default could kill the sovereign CDS market turns out to have been surprisingly popular, especially among policymakers who are worried about whether there’s a serious flaw in the CDS architecture. So today I had a fascinating chat with David Geen, ISDA’s general counsel, to double-check whether there was something I was missing. And it turns out that I was wrong: I wasn’t pessimistic enough. The problem I identified with Greece’s default isn’t just a problem for sovereign CDS: it’s a problem for all CDS.

At heart, the problem is what happens when an issuer swaps out all of its bonds for some new bonds. There’s no reason at all why the new bonds should trade at a massive discount to par — indeed, issuers often like it when their new bonds trade at or near 100 cents on the dollar. But if the CDS auction happens after the bond exchange, and if all of the old bonds are exchanged, then holders of the new bonds are forced to tender new bonds into the exchange, even if they’re trading at 100 cents on the dollar. Which means that holders of old bonds could suffer a huge haircut in the value of their bonds, but still get no payout from their CDS.

This has been an issue in the past. When Anglo Irish Bank restructured its bonds, it amended the old bonds to include a call option which allowed the bank to buy back every €1,000 of bonds for €0.01. That was an effective way of wiping out the value of the old bonds — but it also risked serious damage to the CDS market, since in a CDS auction, the value of a bond is calculated as the price of the bond considered as a percentage of the outstanding principal — and the outstanding principal is considered to be not the face value of the bond but rather the amount of the call option. If Anglo Irish had done the exchange quickly, before a CDS auction was possible, then bondholders would have had to tender bonds with a call option at €0.01 — which would mean that they couldn’t claim any payout on their CDS at all.

In the end, Anglo Irish took pity on the CDS holders, and staggered its restructuring so that there was enough time for ISDA to conduct an auction before the bonds got changed out of all recognition. But hoping that the issuer will act in a friendly manner is not exactly an optimum strategy — especially since, by definition, the issuer will be in the process of going bust.

This is a known issue. In a primer on sovereign state restructurings and credit default swaps dated October 2011, ISDA’s own counsel, Allen & Overy, said as much on page 20.

If an issuer has inserted a right to call at 20%, the outstanding principal would be considered to be 20% of the face value: if it were likely that the call would be exercised, the current value of a bond with a face value of USD100 would be approximately USD20, ie close to 100% of the outstanding principal. If an auction final price was based on this bond, a buyer of protection would receive only a marginal payment in settlement of its credit default swap, rather than a payment reflecting the full diminution in value caused by the restructuring.

The buyer of protection would also lose out in the more straightforward case where all deliverable obligations are redeemed prior to settlement.

This seems unsatisfactory at first blush, particularly as it is effectively the very thing for which protection is bought (the restructuring event) which thwarts the buyer.

This doesn’t just seem unsatisfactory at first blush; it is unsatisfactory. And there is no second blush. Essentially, CDS holders are reduced to hoping that the issuer will be nice, and structure the exchange in such a way as to let them get paid out. But there’s no particular reason why the issuer should do that, especially seeing as how the CDS holders were the people who were effectively shorting the issuer as it tumbled into bankruptcy.

Nearly all issuers in Europe have collective action clauses in their bonds: any of them could ask their bondholders to agree to change the payment terms on all bonds so that call options were introduced or principal amounts reduced. If a supermajority of bondholders did that, then the issuer could change the payment terms immediately, before a CDS auction could be held, and buyers of protection could find that CDS protection to be worthless.

In the past, ISDA has found a slightly kludgy way to deal with this. If you look at the documentation for the CIT auction in 2009, you’ll find this piece of crystalline prose:

If, after the date that is two Business Days after the Notice of Physical Settlement Date, but prior to Delivery, a Deliverable Obligation specified in the Notice of Physical Settlement (or NOPS Amendment Notice, as the case may be) is redeemed and/or cancelled in whole or in part (either in accordance with the terms of the relevant Deliverable Obligation, or otherwise) and, in connection with such redemption and/or cancellation, holders of the Deliverable Obligation receive cash, securities, rights and/or other assets (whether tangible or otherwise) (in each case, whether of the relevant Reference Entity or of a third party) (together, the “Assets”) (such event, an “Asset Exchange”) then, notwithstanding Section 3.4, Buyer’s right to Deliver each relevant Deliverable Obligation shall, to the extent it is the subject of an Asset Exchange, be replaced by a right to Deliver an amount of Relevant Assets equal to, or greater than, but not less than, the Asset Entitlement Amount (together with any part of the Deliverable Obligation that has not been the subject of such Asset Exchange).

I’ll translate that into English for you: the auction might happen after your bonds have been exchanged into something else, which we’ll call Relevant Assets. If that happens, then you’re allowed to consider whatever Relevant Assets you got to be deliverables as far as the auction is concerned. Even if the Relevant Assets are equity rather than debt.

But there’s no indication that this kind of language is going to appear with respect to the Greek restructuring. And there’s no reason for CDS holders to believe that it will appear when bond exchanges happen. And there’s certainly nothing in the existing CDS boilerplate indicating that any such language should ever appear.

If you own protection on a credit, then, you’re very much in a world of caveat emptor. You can trade in and out of CDS and make a good living; these things are, first and foremost, trading vehicles. That’s why they’re more liquid than bonds. But if you have a strategy which involves actually getting paid out on your CDS in the event of default, then you should definitely worry that the payout might not happen, even if the event of default is clear and declared. What’s more, there’s really no good way to hedge that risk.

So far, the CDS market has managed to muddle through, when it comes to restructurings and bond exchanges. But it’s sure to blow up sooner or later. And I’m far from convinced that ISDA and Allen & Overy are capable of reworking the standard documentation to make it more robust to these risks.


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Who gives a toss about CDS “Failing”? CDS is a way of growing balance sheets by “hedging” risk; it has no legitimate purpose, because it can only function when it *isn’t* being used as proper insurance (that is, when some people can use it to scam others).. But once everyone starts selling/buying it, all you get is an ever-larger chance for systemic meltdown. Let the CDS market die.

Posted by Foppe | Report as abusive

Foppe, I was going to say I don’t care if CDS markets crash. But then I thought back to 2007, when I thought there would be massive defaults on mortgages, but didn’t worry because I didn’t own bonds or stock in financial firms, and had no outstanding debts that I had to worry about. And yet I was totally hammered by the ensuing meltdown, as everything I owned lost 40% of its value.

I’m not worried about the first order effects of problems in the CDS market. I am concerned about the second and third order effects, as I’m sure somebody who is playing with somebody else’s money is going to make other people suffer.

Posted by KenG_CA | Report as abusive

A lot (and here I mean tens to hundreds of trillions of dollars) of these CDSs were designed to net to zero; the issuing bank buys one risk, sells an allegedly identical risk, and pockets some profit (hopefully). There was a lot of risk slicing-and-dicing, but it was all supposed to net to zero and go away.

The sorts of considerations you mention above could easily mean that the risks behave asymmetrically; they don’t net to zero. The face values on these CDSs are so huge that even slight asymmetries could take down major banks.

As Lily Tomlin said, no matter how cynical I get I can never keep up.

Posted by JayCM | Report as abusive

I thought Schiff grew up in New Haven?

Posted by maynardGkeynes | Report as abusive

“And I’m far from convinced that ISDA and Allen & Overy are capable of reworking the standard documentation to make it more robust to these risks.”

Is that your professional legal opinion, Felix? Oh, wait…

Posted by Than | Report as abusive

Interesting. Would seem to give an incentive to CDS holders that also hold bonds not to participate in the PSI. And I guess the reverse could also be theoretically true if there are any CDS issuers that hold bonds as well, although this seems less likely.

Anyway, as I have said before, I think this is only a theoretical issue for Greece. To my understanding, even with the CAC Greece does not get to cram-down the minority unless 90% of the bonds are exchanged which I think is quite unlikely.

The way the exchange works is that Greece needs at least 66% of the holders to consent before the CAC is triggered and they can swap the new bonds for the old bonds, although they have said that if they don’t get to at least 75% they will cancel the exchange. If they get between 75%-90%, Greece will swap the bonds that have been tendered but not cram-down the minority.

So my bet is that either the whole thing will fail or there will be some new bonds and some old bonds on the market for a long long time. I assume the old bonds will go into default on 20 March and the CDS auction can occur anytime after that.

Least likely in my view is that the old bonds disappear entirely.

Posted by Gennitydo | Report as abusive

Very interesting post. That retroactive-call-option route is just another proof of how underdeveloped the entire legal framework for the CDS market is.

I’m not so sure about “There’s no reason at all why the new bonds should trade at a massive discount to par”, though. Ask the Greek bondholders who are swapping their old bonds into the new 30 year instruments next week – I don’t think they expect them to trady anything near par. Guesses are that this will be more like 50 cents on every euro of new face value…

Posted by jashu | Report as abusive

We know that the dealers had better information with regards to CDS pricing via MARKIT than the buy-side. We also know that CDS contributes to systemic risk as we saw in AIG and again in the Euro-crisis, and now we know that the casino is rigged as to not pay-out when one holds the winning chips. We also know that CDS allows banks to approach their regulators regarding a reduction in risk capital, a reduction in risk that’s more optics than real considering the banks are exposed to one another. So the conclusion is why are we allowing a market to continue that was deemed pure gambling(see bucket shops) back after the Stock Market crash of 29.

Posted by Sechel | Report as abusive

This is NOT an authentic Will Rogers quote, although it is often attributed to him: I’m not as concerned about the return on my money as I am the return of my money.

It will take the losses of trillions, much crying, and infinite puditry before people figure out that pieces of paper are no more valuable than the man who made the promise to pay you back.

Posted by fresnodan | Report as abusive

Felix, I thought your earlier suggestion (tendering the packaged compensation in the CDS auction) made a lot of logical sense. Why would that be illegal? Why could that not be made legal?

Posted by TFF | Report as abusive

Would be hard to justify delivering the package, it contains securities to cover accrued interest that CDS buyers aren’t entitled to.

Posted by alea | Report as abusive

Ah. What a mess!

Posted by TFF | Report as abusive

Sechel, the buyside can use this new fangled technology called a “phone” to “call” dealers and ask for what we in the biz call a “quote”. Amazing what you can do with technology…. Assuming of course they can’t be bothered to type into a BBG terminal.

Posted by Danny_Black | Report as abusive

Pricing means knowing the size and volume of prior trades, who holds which position, etc. There’s a lot more that goes into this than calling up a few dealers for competing quotes or looking up posted bid/ask spreads of similar quality to BBA libor postings.

Posted by Sechel | Report as abusive

JayCM: they can only net to zero if you ignore time and assume perfect liquidity. Doing so is not particularly realistic.
Secondly, whereas insurance becomes cheaper when more people enroll, CDS gets ever more dangerous, because the distribution of risk leads inexorably to the chances for big problems cropping up all at once rising. In other words, the insurance analogy is propaganda.

Posted by Foppe | Report as abusive

Sechel, so you have real time info on who holds what in AAPL?

Foppe, yet another example if talking gibberish.

Posted by Danny_Black | Report as abusive

Ever noticed how all insurance is a scam?
Why do societies have a love affair with the scam that is insurance in all its many forms?
Insurance like Governments are Santa Claus(e) for adults.

Posted by JP007 | Report as abusive

“Ever noticed how all insurance is a scam?”

JP, it is all about income smoothing. Insurance is an EXPENSE that people voluntarily incur so that their costs will be more predictable. Better to spend $1000 annually than to spend $0 most years and then get hit with a $19,000 charge one year out of twenty.

That said, most people buy far too much insurance. Insurance should begin with a large deductible. If you have $5k in the bank, then your insurance policies should all have at least a $1k deductible off the top. If you have $50k in emergency savings, then a $10k deductible is not excessive. Priced properly, high-deductible policies eliminate paperwork and save you money — which you can put towards a healthy emergency savings account.

If you have no savings, then you are forced to insure against even the smallest unanticipated expenses. That gets very expensive, very quickly.

Posted by TFF | Report as abusive