Greece’s CDS: more lucky than smart

By Felix Salmon
March 9, 2012
It's official.

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It’s official:

The International Swaps and Derivatives Association, Inc. (ISDA) today announced that its EMEA Credit Derivatives Determinations Committee resolved unanimously that a Restructuring Credit Event has occurred with respect to The Hellenic Republic (Greece).

The word that jumps out at me here is Restructuring. In Europe, restructuring counts as a credit event; in north America, by contrast, it doesn’t. Which means that the derivatives market was pretty lucky here. If the standard Greek CDS documentation had looked like the standard US CDS documentation, there wouldn’t have been a credit event, as ISDA spokesman Steve Kennedy confirmed to me via email:

If you own CDS, and if you do not have restructuring as a credit event in your contract, it would not trigger if a CAC were invoked. You would know this going in. It is not a surprise.

The issue of restructuring as a credit event has been discussed for a decade. In other words, where restructuring is not a standard credit event (such as for US corporates), protection buyers buy the CDS protection knowing that there is no restructuring clause, that the credit event triggers are failure to pay and bankruptcy (for corporates) and repudiation/moratorium (for sovereigns), and the CDS is priced accordingly.

Now this isn’t quite as scary as it looks at first glance, because while US bonds do include CACs, if you want to amend the payment terms, you typically need 100% of the bondholders to agree to change the terms. A CDS holder could therefore buy a single bond and thereby ensure payment default and CDS payout.

But still, the whole CDS saga in Greece and elsewhere does rather feel as though ISDA is making it up as it goes along. Check this out, from the official FAQ:

How can an auction be held if there are no “old bonds” because they have been exchanged for new bonds?

The EMEA Determinations Committee will ultimately decide which of the obligations are deliverable under the Credit Derivatives Definitions for purposes of the Greek CDS settlement auction. It is important to note that Greece has outstanding a wide variety of obligations. Not all existing bonds are covered by the use of CACs. In addition, new bonds are being issued that might satisfy the requirements for deliverable obligations.

In other words, yes, the CDS market looks a little bit broken, but we’ll muddle through somehow, and hey, you never know, maybe the new bonds will work as deliverables after all.

There was a good hour’s worth of confusion about the credit event earlier today, when ISDA first declared that it had happened, and then pulled the release from its website — it seems because the original release couldn’t get the timing right for the associated ISDA press briefing and webcast.

Greece is now the second high-profile CDS case which could have gone horribly wrong for investors who thought they were actually protecting themselves when they bought protection. First came AIG, which ended up paying out on its CDS obligations at 100 cents on the dollar, although that decision was highly controversial. AIG’s Joe Cassano reckons that AIG shouldn’t have paid out anything at all, since the underlying obligations hadn’t actually defaulted. The problem was that AIG itself was downgraded, and couldn’t come up with the requisite margin; as a result, it had to unwind the CDS it had written at the bottom of the market and at enormous cost. And of course most of the rest of us reckon that because AIG was insolvent, its creditors/counterparties shouldn’t have got everything they were owed, and should instead have taken some kind of haircut.

Now comes Greece, which seems as though it will pay out at roughly the right level, if only because the EMEA paperwork had a restructuring clause, and because it had some obscure foreign-law bonds which can be used as deliverables.

Going forwards, then, I can’t imagine that investors will have much if any confidence that CDS will really perform the hedging function they’re designed for. My feeling is that if you look at the numbers for total single-name CDS outstanding, they’ll decline steadily from here on in. Because you ultimately can’t trust them when you really need them.


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“The word that jumps out at me here is Restructuring. In Europe, restructuring counts as a credit event; in north America, by contrast, it doesn’t. Which means that the derivatives market was pretty lucky here. If the standard Greek CDS documentation had looked like the standard US CDS documentation, there wouldn’t have been a credit event”.

You’re confusing CDSs on sovereigns and CDSs on corporates here. A standard sovereign CDS on the U.S. (or any other sovereign for that matter) includes Restructuring as Credit Event. “A CDS is triggered when a Credit Event occurs. There are three Credit Events that are typically used for Sovereigns such as the United States. They are: Failure to Pay; Repudiation/Moratorium and Restructuring.” (ISDA: reign-debt-qampa).

The reason that CDSs on US corporates don’t include Restructuring (and those on European corporates standardly do) is that in the US restructuring is in practice effected under Chapter 11 of the Bankruptcy Code, which means that you don’t need Restructuring as long as you’ve got Bankruptcy. But for sovereign, Bankruptcy is never included (since they can’t be declared bankrupt). Hence, Restructuring always is.

Posted by Kamekon | Report as abusive

On a certain level, this is all very simple. First, Greece can’t pay what it owes. Second, Greece can’t afford needed food, medicine, and fuel without help. So Greece is likely to make whatever gestures are necessary to keep people throwing good money after bad for as long as they can. When Greece’s creditors wise up and try to become net wealth extractors, any Greek politician who even contemplates a bond payment will be swinging from a lamppost within minutes. That goes double for any foreign viceroy.

Posted by JayCM | Report as abusive

JayCM, I think you’re overestimating the Greeks in the streets and underestimating the German, IMF and ECB econocrats. The Germans have been saying since at least January that they want to install essentially a Kommissar to take control of the Greek budget, and they’re likely to do this much sooner than the point you’re describing. They
understand why they have leverage and for how long. 4b64-11e1-b980-00144feabdc0.html

since Germans are in the drivers seat when the troika meets, they can always tell the Greeks that if they don’t put the Kommissar in place, Greece won’t get the next tranche of the bail out money already promised to them.

I’d love to be proven wrong, but I’m not seeing how Greece can get out of this without leaving the Eurozone and I’m also not seeing Greeks staging a revolution.

Posted by Strych09 | Report as abusive

Except in neither case did it go “horribly wrong” nor was there much chance that it would behave contrary to expectations except amongst idiot journalists and pundits. CDSes have performed as expected under extreme stress and despite repeated claims by the press never come close to causing a catastrophe that they always claim is around the corner.

Your claim as to what happened in AIG again is a misrepresentation. The CDSes did not “pay out”, there were no defaults – to the best of my knowledge, certainly not a significant number. Rather AIG had to keep pumping out cash as collateral at the same time the brain donors in the treasury dept of AIG decided to earn a few extra bips investing in illiquid mortgage backed bonds. It didn’t “unwind” the CDSes at the bottom of the market, it simply swapped the CDSes for the underlyings and cash collateral. On what basis do you claim that the counterparties would not have got everything they were owed? Especially given that those assets turned a not insignificant profit, even after the “enormous cost”.

You know this, people have pointed out to you repeatedly. Why do you keep parroting these lies?

Also please do us a favour and buy a finance for dummies books that explains the difference between sov and corp debt.

Posted by Danny_Black | Report as abusive

Another curly for ISDA to fudge?

The not-so-sweet smell of odious debt
A proposal that declares obligations of a particular regime non-transferable frees innocent people from indenture not of their making -sweet-smell-of-odious-debt/comment-page -1/#comment-4559

Posted by polit2k | Report as abusive

interesting article felix

the fact that greece is successfully moving through the stages of restructuring its debt has annoyed commentators looking for a fiscal armageddon

and you are correct in asking whether the CDS is a worthwhile hedging instrument

Posted by scythe | Report as abusive

you might want to hold off a bit before trumpeting success

Posted by Danny_Black | Report as abusive

It appears to me that the only reason the CDS worked this time is due to the time gap between the March 12 date on which the Greek-law bonds will receive their restructuring package and the mid-April date on which the English-law bonds receive their restructuring package.

By setting the March 19 date for the auction, ISDA has been saved solely by the tiny, untendered remnant of the foreign-law bonds which will be both “Deliverable” and yield the correct economic result when delivered.

Only untendered bonds can be delivered because anything tendered is frozen in Euroclear and cannot be transferred until completion of the exchange.

As to the fruits of the exchange,it seems to me that only the EUR 315 of bonds is actually Deliverable (in the ISDA sense); the GDP warrants aren’t Bond or Loans and the EFSF bonds are not Obligations of the Reference Entity.

But “Deliverable” (in the ISDA sense) doesn’t mean that delivery gives the right economic result. One would still be left with the problem you’ve been pointing out for the last weeks: the CDS payout is based on the post-writedown face.

However, by pure happenstance, there will be some number of untendered foreign-law bonds which will inevitably (but have not yet at auction settlement) turned into pumpkins. And that’s the only reason that the CDS “work”.

It’s better to be lucky than good.

Posted by Chris_A | Report as abusive

hold off? ha – haa – haaa

the solution to the problem has been and continues to be greater than a small-minded thirst for fiscal armageddon

and the resilience of the euro even more

Posted by scythe | Report as abusive

to strych09: Sure, if there’s another bailout coming, the Komissar will be accommodated. But only as long as the bailouts keep coming, and remain net subsidies to Greece. After that, the Komissar is a tetherball.

To actually pay the debts, Greece has to pay out more (to bondholders) than it takes in from bailouts. That’s not going to happen, and anything else is just more “extend and pretend”.

Posted by JayCM | Report as abusive

ISDA vote these days will be made by the adhering to sellers and non-sellers. It will be up to them to make a decision if they wish to demolish the very last trace of “integrity” of the CDS marketplace and in influence commit institutional suicide. rtion-on-psi-says-e172-billion-of-bonds- tendered-in-swap-will-enact-cacs-isda-to -meet-up-with-at-1pm-to-uncover-if-cds-c ause

Posted by ClintTrader | Report as abusive

@ Danny_Black: I very much appreciate and usually agree with your comments on Felix’ blog. For that very reason may I gently encourage you to try and cool your temper before firing off insulting remarks (even if substantially correct) at other commenters or indeed Felix. It would be a real shame if others felt they have to retort in kind or, worse, you might be blocked from the comments. No irony.

Posted by Abulili | Report as abusive

Abulili, sure. I mean we are all wrong at least some of the time. However, when you say something factually incorrect and someone corrects you and then you continue to repeat that incorrect statement then at some point it is valid to question whether in fact you are interested in the truth or not.

This goes for people like Jesse Eissenger, Gretchen Morgensen and the FED-bashers at Bloomberg. If these people were random commentators mouthing off – like me and presumably you – then who cares but the media deliberately making incorrect statements does have a real world impact.

Posted by Danny_Black | Report as abusive

Given that we’ve seen that there is a huge number of deliverables, including the restructured bonds, here’s a question I’ve seen no one answer:

If you go into the 2nd stage of the auction, looking to buy, you give a price at which you would be happy owning the DO. But which one do you get? Even within the maturity buckets, there are multiple bonds with varying fundamentals.

Posted by KFSalisbury | Report as abusive

I very much appreciate and usually agree with your comments on Felix’ blog.

Posted by feitian | Report as abusive

@KFSalisbury: CDS contain a “cheapest to deliver” option. So whoever buys in the auction should assume that it will get whichever of the obligations the seller into the auction can buy cheapest. I’d imagine that would be the already-restructured Greek law bonds (since those would be delivered ex the GDP warrant and the FSF bonds). That’s not to say that CDS work as a hedge (for the reason Felix has described already).

Posted by Chris_A | Report as abusive

No actually, I need coffee. The cheapest to deliver on a per EUR 1K face amount will still be the non-restructured non-Greek law bonds, since they will turn into EUR 315 face any day now. Derp.

Posted by Chris_A | Report as abusive

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