Greece’s CDS: more lucky than smart

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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