Could Spain’s bank bailout trigger its CDS?

By Felix Salmon
June 11, 2012
Matt Levine has an excellent post on the latest storm in a CDS teacup, which has been prompted by Europe's bailout of Spanish banks.

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Matt Levine has an excellent post on the latest storm in a CDS teacup, which has been prompted by Europe’s bailout of Spanish banks. If you feel any need to follow this kind of thing at all, here’s basically what you need to know.

Firstly, this bailout is going to add a good €100 billion or so to Spain’s national debt, over and above its existing bonds. That in and of itself makes Spain less creditworthy: the more debt you have, the lower the chances are that you’re going to be able to pay it all back.

More worryingly, for holders of Spain’s national debt, this new bank-bailout debt (which is owed by the country of Spain, remember, since the money isn’t going directly to the banks) carries something known as preferred creditor status. That means that if push comes to shove, Spain will repay the bailout debt before repaying any of its bonds.

To take a simplified example: if Spain has €100 billion in bailout debt due and another €200 billion in bond payments due, and only has €150 billion on hand, then an equitable treatment would be to ask each of its creditors to take a 50% haircut. But with preferred creditor status, Europe will get its €100 billion back in full, and bondholders would have to take a 75% haircut. So holding Spanish bonds just became significantly riskier, this weekend.

Now here comes the CDS angle: if this subordination is written into European law, does that mean that the Europeans just subordinated Spain’s bondholders? Because if they did, then that might count as a credit event, and allow anybody holding Spanish CDS to trigger those CDS and ask to be paid out in full.

There’s lots of discussion here about the difference between the two different places that the money for the Spanish bank bailout might come from: the EFSF, on the one hand, and the ESM, on the other. The ESM’s preferred-creditor status is enshrined in law; the EFSF’s isn’t. In practice, as Joseph Cotterill points out, they behave the same way: European countries will treat the EFSF exactly the same way they treat the ESM, and the EFSF managed to get away haircut-free in the Greek restructuring. But as far as CDS documentation is concerned, what happens in practice doesn’t matter. What matters is the legal theory.

And when it comes to the legalese, it doesn’t get much more impenetrable than this:

“Subordination” means, with respect to an obligation (the “Subordinated Obligation”) and another obligation of the Reference Entity to which such obligation is being compared (the “Senior Obligation”), a contractual, trust or similar arrangement providing that (i) upon the liquidation, dissolution, reorganization or winding up of the Reference Entity, claims of the holders of the Senior Obligation will be satisfied prior to the claims of the holders of the Subordinated Obligation or (ii) the holders of the Subordinated Obligation will not be entitled to receive or retain payments in respect of their claims against the Reference Entity at any time that the Reference Entity is in payment arrears or is otherwise in default under the Senior Obligation. … For purposes of determining whether Subordination exists or whether an obligation is Subordinated with respect to another obligation to which it is being compared, the existence of preferred creditors arising by operation of law or of collateral, credit support or other credit enhancement arrangements shall not be taken into account, except that, notwithstanding the foregoing, priorities arising by operation of law shall be taken into account where the Reference Entity is a Sovereign.

Christopher Whittall has found some lawyers willing to stick their necks out and translate this into English. Basically, there are two ways that CDS can be triggered on the grounds of subordination. The first one is moot, since it applies to entities which can be liquidated, and therefore clearly doesn’t apply to sovereigns. The second one is a bit more complicated, but it basically comes down to the question of whether Spain would be allowed to pay its bondholders if it was in arrears to the ESM. And that’s a question of Spanish law, not European treaty. Unless and until the Spaniards pass a law to that effect, the CDS probably can’t be triggered — which isn’t to say that some enterprising hedge-fund manager somewhere isn’t going to give it the old college try.

Even if the CDS were triggered, however, that wouldn’t be the worst thing in the world. So long as Spain keeps on paying its bond payments on time, the CDS auction, were there to be such a thing, would happen at a pretty high price, and would be no big deal. Think of the auction for Fannie Mae and Freddie Mac: they both had a credit event, but the clearing price was basically par, so holders of CDS didn’t make any kind of profits.

And more generally, the fact that the European Union has been so blasé about these matters is definitely encouraging. Once upon a time, lots of Eurocrats seemed to think that they really had to worry about the CDS market, and whether there was a credit event in Greece. Now, in the wake of the Greek restructuring, they’ve grown up, and they understand that the credit derivatives market is not important enough to worry about or to build policy around. They’re going to do their thing, and the CDS market will react as it may. (Including, perhaps, by just giving up on the whole sovereign-CDS thing entirely.)

In other words, the subordination matters; whether or not the subordination constitutes a credit event under ISDA rules, not so much. As the EFSF and ESM continue to disburse money to the European periphery, that’s the thing to concentrate on most: how much money have they given out, and when do they need to be repaid? Because all of those payments are going to come first, before any payments to bondholders.

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