Felix Salmon

One of the hardest questions to answer, when people ask about the European crisis in general and the Greek crisis in particular, is “why should we in the US care?” The simple answer is that well, this is an important part of the world, and it’s big news. But if you only care about news insofar as it directly effects the US, then the answer is harder.

One possible answer — I’ve heard this given in a number of places — is that another major crisis in Europe would spill over into the US, cause serious economic damage here, and could quite possibly make the difference between an Obama and a Romney victory. But just how likely is that? I’m no expert when it comes to assigning probabilities to events, but we can at least come up with a general framework which lets us answer the question.

Let’s start with the fiscal pact. Will all of Europe credibly commit to fiscal austerity going forwards? If so, that increases the chances of crisis and Grexit, since southern European countries in general, and Greece in particular, simply can’t operate under an austerity regime in the way that, say, the Baltics have managed, painfully, to do. On the other hand, everybody seems quite likely to break the fiscal pact in one way or another — which means that there has to be a good chance the pact will end up being honored mostly in the breach. Let’s call the probability of a Europe-wide austerity regime A; my best guess for A is roughly 15%, or 0.15.

So the next question is — what is the probability of Grexit, any time soon? That’s really two questions. First, what is the probability of Grexit if there’s Europe-wide austerity. Let’s call that B, and I’ll peg it at 85%, or 0.85. Second, what’s the probability of Grexit if Europe-wide austerity slips a bit? We’ll call that C, and I’ll say it’s 65%, or 0.65. Overall, we can define the chance of Grexit, D, as A * B + (1-A) * C. If you’re playing along at home, that’s 0.68, or 68%.

But just because Grexit happens, doesn’t mean it will necessarily affect the US election. For one thing, by definition, Grexit can’t affect the US election if it hasn’t happened by the time the election takes place. So the next question is: if there’s Grexit, what are the chances that it will happen by November? The Europeans have proven themselves very good at kicking the can down the road, so even if Grexit is inevitable, it’s still not inevitable by November. In any case, let’s define E as being the conditional probability of Grexit by November, given Grexit. I’ll say that’s 50%. Which means that the overall probability of Grexit by November, F, is D * E, or 34%.

Grexit, if and when it happens, will cause a lot of disruption in European markets, and certain deposit flight out of Spanish and Portuguese banks. Again, there are two ways this can play out. Either it will cause a series of further dominoes to fall, or else it will concentrate the Europeans’ mind and force them to build a large and genuinely effective firewall, drawing a line in the sand and saying “this far, but no further”. Will Europe let the Grexit crisis go to waste? Let’s say the probability of a credible, coordinated and constructive pan-European response to Grexit is G. Then the probability of Grexit causing a big European crisis is 1-G. What’s G? That’s a tough one, but I’ll put it at 35%.

For the purposes of this calculation, we’ll assume that Greece alone is too small to cause a big global crisis: you need contagion, for that. So we’re looking for H, the chance of a big European crisis before the US election. We can calculate that as F * (1-G), or 22% — that’s the chance of Grexit before November, multiplied by the chance of a bigger crisis if Grexit happens. (Note that a big European crisis can happen at any time; the chance of that is D * (1-G), which works out at 44%.)

If we have a big European crisis before the election, then that will certainly send US stocks falling. But will a sharp drop in the US stock market have any effect on the outcome of the election? Probably only if the election is reasonably close — and certainly not if Romney is in the lead. A European crisis, and consequent plunge in US stocks, would only be good for Romney and bad for Obama, just as the crisis in the fall of 2008 was good for Obama and bad for the incumbent Republicans. So what we’re looking for, here, is I, the probability that Obama will have a narrow lead over Romney — one small enough to be erased by a big stock-market plunge. I’ll peg I at 65%.

And thus, finally, we get to the big answer: what is X, the probability of Grexit toppling Obama? That is H * I, which using my off-the-top-of-my-head probabilities, works out at about 14%. But you should work this out for yourself. Come up with your own values for all these:

A: What is the probability of a Europe-wide austerity regime?
B: If we get Europe-wide austerity, what are the chances of Grexit, any time soon?
C: If we don’t get Europe-wide austerity, what are the chances of Grexit, any time soon?
D: What, then, is the probability of Grexit? This is calculated as A * B + (1-A) * C.
E: If we have Grexit, what are the chances it’ll happen before the election?
F: This is the overall probability of Grexit before the election, and is D * E.
G: If we have Grexit, what are the chances of it eliciting a credible, coordinated and constructive pan-European response?
H: This is the probability of a big European crisis before the election, it’s F * (1-G).
I: What is the probability of Obama having a narrow enough lead over Romney that it would be erased by a plunging stock market?

Put these all together, and you can finally come up with a number for:

X: The probability of Grexit toppling Obama. It’s H * I.

I’d be interested to know what results you get, but my guess is that most of them will come up with a number which is low and yet still significant. It’s something to bear in mind, but of course it’s also something which is pretty much entirely out of Obama’s control. That’s the way that crises work: individual politicians are rarely personally responsible for them, but whomever’s in power when they happen nearly always ends up getting the blame.

The size of the run on Greek banks is not at all clear: while it seems that something on the order of €1 billion has left the banks of late, it’s less obvious whether that was over the course of one day, three days, or two weeks. The big picture, though, is unambiguous:

What you’re seeing here is Greece down to its last €165 billion or so in deposits, and at the margin the rate of decrease is probably accelerating, despite the fact that most sensible Greeks will have already stashed their hard-earned euros safely outside the country a long time ago. I don’t know what the minimum amount is that Greeks need on deposit just to serve their near-term liquidity requirements, but we’re not there yet: Greece’s total population is only 11 million. So there’s a long way further this number can fall — especially since the Greek banking system isn’t receiving the support it needs from the ECB.

The more realistic constraint is simply that many Greeks lack the education and sophistication and language skills needed to move their money out of the country. This, for instance, is telling:

A 60-year-old textiles store owner who gave his name only as Nasos said he had transferred 10,000 euros over the phone to a bank in fellow euro zone state Cyprus on Tuesday afternoon.

If Greece exits the euro, there’s no doubt that there will be a massive banking crisis in Cyprus — it’s pretty much the least safe haven conceivable for someone looking to move their money from Greece. The only reason to move money to Cyprus rather than, say, Luxembourg is that they speak Greek there, and the logistics of moving money to Cyprus are easier than the logistics of moving money to any other country.

Meanwhile, in the rest of the eurozone periphery, foreigners are already pulling their deposits from Italian banks, while the Spanish banking system is only getting increasingly precarious:

All of which is to say that the causal relationship between sovereign crises and banking crises is rather more complicated than one causing the other: in reality, they cause each other, in a vicious cycle which clearly isn’t close to being broken in any of the southern European states. Greece is further along in the cycle than Spain or Portugal or Italy, but they’re all still moving in the wrong direction.

Greece’s banks, remember, are the mechanism by which the rest of Europe will force Grexit. Banks are the circulatory system of any economy: if they stop pumping money, the country dies. And so, in extremis, Greece will need to do a complete blood transfusion, replacing all euros with drachmas, if the only alternative is to see the flow of euros dry up entirely.

In the meantime, however, expect to see deposits continue to leave Greece — and the rest of the European periphery as well. Even if your euros are reasonably safe in a big Italian bank, they’re surely safer in a big German bank. And the first thing that all depositors want is safety. Now that questions have been raised about the solvency of various southern European banking systems, it’s going to be very hard to reconstitute the eurozone in a robust fashion. The Eurozone was never designed to cope with millions of Spaniards moving their money out of the country, behaving like middle-class Venezuelans with offshore accounts in Miami. And it also was never designed to cope with capital controls. But increasingly, it looks like we’re going to end up with one or the other. Or both.

The word on everybody’s lips these days is Grexit — Paul Krugman, for one, reckons it could be here as early as June. But how would such a thing happen? The FT, in its otherwise excellent Grexit explainer, fudges that bit:

Exit would occur because, without disbursements of additional loans, the government would run out of money to pay social security and public sector wages. In addition, the ECB could withhold needed funds from Greek banks, bringing them down. At this point Athens would need to pass a new currency law, redenominate all domestic contracts in a new drachma, impose exchange controls, secure the borders to limit capital flight and take steps to introduce a paper currency.

It’s true that Greece is currently running a substantial fiscal deficit, which is being funded by the EU. If the EU stopped disbursing loans, Greece by definition could not meet all of its obligations. But the thing that happens when you can’t meet your obligations is known as a default — and as we’ve already seen, Greece is more than capable of defaulting on its obligations without exiting the euro.

So the question is: given that leaving the euro would be political suicide for any Greek politician, why would any such politician go ahead and do it anyway?

Luke Baker has the beginnings of an answer:

The rules would appear to leave the decision largely in the hands of the departing country. But when asked if that were the case during a meeting in Brussels last week, German Finance Minister Wolfgang Schaeuble said it was not necessarily so.

According to a source present at the meeting, Schaeuble said contingency plans were being drawn up and indicated that life could be made so unpleasant for Greece that it would be left with no other option but to ask to leave.

That could involve shutting off all Greece’s official financing, not just from the euro zone’s EFSF bailout fund but from the European Central Bank too. Already there are signs of that sort of pressure being applied to Athens.

It seems obvious to me that if Greece were not receiving any money from the EU and the IMF, and the relationship there turned highly adversarial, with the EU effectively trying to force Greece out of the Eurozone, then Greece would feel no particular need to pay the EU what it is owed. And if Greece were to default to the EU, then at that point it would gain little from staying current on its other debts, too. It might still pay the IMF, and try to maintain some kind of decent relations there, but my guess is that Christine Lagarde would be foursquare behind Brussels, and the Greeks would see little point in paying her either.

Up until now, only pariah countries have defaulted to the IMF, but Greece is the exception to many rules. And given the choice between default and devaluation, it seems to me that Greek politicians — and the Greek population as a whole — clearly prefers the former to the latter.

Once you strip out Greece’s debt payments, the country’s primary deficit is pretty modest — just 1% of GDP or so. So could Greece make one more round of cuts, default on all its debts, and remain within the Eurozone?

I think the answer is no — and the reason is the banks. If the ECB were to stop funding the Greek banks, and if Greece were to default on its debts, all of Greece’s banks would be insolvent. And you can’t have a functioning economy without banks. Basically, Greek depositors need to be able to withdraw something from their checking accounts. And if the EU stops supporting the banks, that something can’t be euros any more.

Back on March 23, Christopher Whittall explained why we don’t have a good go-to measure of Greece’s creditworthiness, in the wake of its big bond exchange: Greece’s credit default swaps can’t trade yet. There’s something called a 60-day look-back clause in the standard CDS documentation, which means that if a country has defaulted in the past 60 days, somebody who owns credit protection can claim that there has been an event of default and ask to be paid out. Since we’re still well within 60 days of the default event on March 9, anybody buying Greek credit default swaps now could trigger them immediately.

But after today’s news, it’s far from clear that Greek CDS will even start trading after the 60 days are up. It turns out that while Greece managed to swap its old domestic debt into new bonds quite seamlessly and easily, the same’s not true of Greece’s foreign bonds.

In a statement, the Public Debt Management Agency said investors holding 20 of the 36 bonds in question either voted down or otherwise failed to approve key changes to the bond contracts…

Last week euro-zone finance ministers issued a statement which hinted strongly that they would back Greece if it didn’t make the payments on foreign law bonds.

On May 15, Greece must redeem one of those foreign law notes worth €450 million.

Basically, there are now roughly €9 billion of bonds outstanding which are still old bonds which haven’t been swapped. And those bonds are likely to be a real headache for Greece. The obvious thing for Greece to do would be to simply refuse to pay anybody who holds those bonds and didn’t tender into the exchange. I would certainly follow that course, if I were in Greece’s shoes.

But that would mean that there would be a second Greek default — and that going forwards, there would be a semi-permanent stock of defaulted Greek debt out there. In turn, that would make it difficult to trade Greek CDS, since Greece is likely to be in default, on billions of dollars of foreign debt, for as far as the eye can see.

Now it’s possible to ring-fence that debt and say that it doesn’t count towards a CDS trigger. Non-trivial, but possible. The question is whether anybody really has the appetite to do that. Or whether Greece, and the Eurocrats paying its bills, would actually be quite happy if Greek CDS didn’t trade at all from here on in.

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.

When I met with Peter Eavis to talk Greece, we finished our conversation with a predictions game: what percentage of Greece’s bondholders would accept its exchange offer? He said 84%, I said 89%. He wins: Greece won the participation of 85.8% of Greek-law bondholders, by value, and 69% of foreign-law bonds. As a result, the vast majority of Greek bonds will end up being exchanged, since the collective action clauses on most foreign bonds and all Greek bonds will now be triggered.

Ideally, Greece would like to bail in all of its bondholders, and so to that end it’s extending its exchange offer for the bonds issued under foreign law, until March 23. (The March 20 deadline no longer matters, because that represented the maturity of a Greek-law bond, which is now being swapped into much longer-dated debt.) There’s a new restructuring offer, too, for “holders of Greek law governed bonds issued by state enterprises and guaranteed by the Republic”, which should deal with the Greek railways loophole.

The Greek press release hammers home why holdouts should tender into the exchange, with a statement from finance minister Evangelos Venizelos:

Our invitations to offer to exchange, and submit consents with respect to, foreign law governed and guaranteed bonds will remain open until 23 March 2012, after which there will be no further opportunity for creditors holding those instruments to benefit from the package of EFSF notes, co-financing and GDP linked securities which form an important and integral part of our invitations.

Remember that the Greece exchange is a package deal with three parts. For every old bond tendered, you get (a) a new Greek bond; (b) new EFSF bonds; and (c) new GDP warrants. Venizelos, here, is saying this is a use-it-or-lose-it opportunity to get all three in one. Greece may or may not continue to swap its old bonds for its new bonds even after March 23. But there’s no way that holdouts will get the EFSF bonds. And the EFSF bonds are actually worth more than the new Greek bonds.

Because Greece is activating its CACs, there will be a credit event for the purposes of its credit default swaps — as there should be. If you sold protection on Greek bonds, then you’ll end up having to pay out roughly 75 cents on the dollar. But given where the CDS have been trading of late, you’ve almost certainly put up that much money in margin already. So there’s nothing unexpected here, and there won’t be any nasty surprises on the CDS front.

The exit yield on Greece’s new bonds is roughly 20%, which means that even after this enormous haircut, markets are still pricing in a very high probability of default on the new bonds. (Which, remember, are all being issued under foreign law, and will therefore be much harder to exchange, next time round.) I suspect that the new bonds could be a buy at these levels. Not because Greece is suddenly fiscally healthy again: it isn’t. But because if and when Greece is forced to do another debt restructuring, maybe when it leaves the euro, the debt servicing costs on its new foreign-law bonds will be relatively small. And it will therefore be easier for Greece to simply keep on paying the interest on those bonds than it would be to try to restructure its bonded debt a second time round.

That’s the silver lining to the step-up coupon on the new bonds: because it starts so low, at just 2% through 2015 and 3% through 2020, Greece doesn’t actually help itself out very much, from a cashflow situation, if it defaults or restructures these things a second time. The pain of the next Greek default, then, is going to fall overwhelmingly on the official sector rather than the private sector.

Of course, if Greece defaults on say the bonds being held by the ECB, then it’s very unlikely that the new Greek bonds would be trading at healthy levels. But what that means is that when you’re looking at the depressed price of Greece’s new bonds, you’re looking mainly at market risk, rather than credit risk: the risk that they will go down in price is much more salient than the risk that they will simply stop paying out altogether. If you have a strong stomach, and can hold on through what will certainly be periods of very high volatility, then there’s a reasonably good chance they will actually pay out in full, over the medium term.

The first maturity date on the new bonds is 2023, and realistically Greece has no particular reason to default on the bonds until then. Even in 2023, the amount coming due is modest enough that Greece would be better off paying it than suffering the consequences of a redefault. Basically, in the wake of this exchange, the new bonds aren’t a big issue any more, from a fiscal perspective.

The really big problem, for Greece — the one which isn’t going away — is the fact that the country still has a massive budget deficit, and that the only people willing to lend Greece the money to cover that deficit, at least for the foreseeable future, are its fellow European sovereigns. And their patience is wearing extremely thin. That particular tension has not been resolved today, and it’s going to come to a head much sooner than any problems with Greece’s new bonds. The next Greek crisis is going to be a crisis with official-sector financing, and it could come as early as this year.

“Greece’s private creditors are the lucky ones,” says Nouriel Roubini — which I think is putting it a bit strongly. Nouriel — who at one point was one of the world’s foremost econobloggers — is falling back on bad habits here: he says that “a myth is developing” about the official sector getting off scot free in Greece, and goes on to tell us how “the argument runs”. But he doesn’t link to any such argument — and I’d dearly love to know who he has in mind, and what exactly they’re saying.

Nouriel then gives a good overview of the degree to which the official sector really is bailing out Greece. This is important to remember: just because bondholders are taking a haircut, doesn’t mean this isn’t a bailout. It is. Greece is running a massive budget deficit, even before interest payments on its debt. It can’t borrow the money to cover that deficit in the markets, either foreign or domestic. Which means that the only thing standing between Greece and bankruptcy is the Troika, throwing billions of dollars at the Greek government to avert insolvency. As Nouriel says, this should give the Troika seniority, on the grounds that they’re providing the equivalent of “debtor-in-possession” financing.

Nouriel’s attempts to paint the private sector’s 75% haircut as a good deal which is “too little”, however, are less convincing. He’s right that once Greece’s new bonds are issued under English law, the Greek government can’t unilaterally convert them to drachmas — or to worthless scrip, for that matter. But as Nouriel well knows, that’s a fact of life for countries of dubious creditworthiness: the markets are always suspicious when they try to issue under their own laws. If Greece wants to give anything of real value to its bondholders, then it has to offer bonds issued under English law, because no one will believe its promises to pay, otherwise.

Put it this way: someone in the Greek government genuinely intends that the country is actually going to make all of its payments on the new bonds. Insofar as the Greek government is believed with regard to that promise, the new bonds are going to have real market value. But in order for bondholders to be able to realize that value, the bonds have to be issued under English law. If Greece came out with exactly the same offer but kept the new bonds under Greek law, then the haircut would be substantially larger than 75%, because the new bonds would trade at a significantly lower price when issued. So the governing-law aspect to all this is already incorporated in the haircut, and by choosing English law, Greece is simply maximizing the value of its bonds without increasing its total indebtedness by a penny.

And this argument of Nouriel’s makes very little sense to me:

Greece’s private creditors should stop complaining and accept the deal offered to them. They will take some losses, but they are limited and, on a mark-to-market basis, the debt exchange offers them a potential capital gain. Indeed, the fact that the new bonds are expected to be worth more than the old suggests that this PSI exercise has further transferred losses to Greece’s official creditors.

The job of the market — which it normally does quite well — is to anticipate how big a Greek haircut is going to be, and then arbitrage Greece’s bonds appropriately, pricing them at a level such that bondholders tendering into the exchange wouldn’t be better off simply selling their bonds instead. (If they would be better off selling their bonds instead, then the buyer of those bonds is pretty stupid, and is going to end up making a loss.) So by definition, an exchange offer always offers “a potential capital gain” to bondholders, just because the market price before the exchange has to be a little bit lower than the expected value of the new securities after the exchange.

What’s more, Greece has to offer something, or else there won’t be an exchange at all, and instead there would just be a chaotic default which would be extremely damaging to all concerned. Already, the majority of the value in the package being offered bondholders is not coming from the new Greek bonds, but rather from European EFSF securities. The value of the new Greek bonds is only about 10 cents on the dollar — a 90% NPV haircut. It doesn’t get much bigger than that.

There are very good reasons why Greece would love to remain a member in good standing of the international community — not least that it wants to remain a member in good standing of the European Union, with Greek banks retaining most if not all of their current deposit base. As such, it has to take its bonded obligations reasonably seriously. The last thing it wants is protracted litigation with bondholders a la Argentina, where bondholders have recently been winning small but important victories in the US courts. Argentina is going to have to spend the foreseeable future being extremely careful with its sovereign holdings, for fear that they will otherwise be attached by its creditors. Greece doesn’t want to be an international pariah like that.

So while I’m shedding no tears for Greece’s bondholders, who took a risk which didn’t pan out, neither am I going to go as far as Nouriel and say that they’re getting a good deal. They’re not. They’re getting 25 cents on the dollar. Just imagine what would happen if Greece tried to make that kind of offer to other holders of sovereign obligations, like its pensioners.

This, I think, is a major change of tune from Greece.

When Greece first launched its exchange offer, on February 24, the language about when and whether it would active its collective action clauses was long and complex. I’ve uploaded the original press release here; the relevant language is at the bottom of page 2 and the top of page 3, and has caused a lot of confusion. (Simone Foxman, for instance, reported yesterday that if Greece gets 90% participation, the CACs would not be activated. That’s the exact opposite of what Greece said in the press release, where it declared its intention “to declare the proposed amendments effective” in that event.)

Today’s press release, by contrast, is a lot simpler. Never mind the old distinctions about what happened if the take-up was less than 66%, or between 66% and 75%, or between 75% and 90%, or above 90%. Instead, we just get one, simple rule:

The Republic confirmed that if it receives sufficient consents to the proposed amendments of the Greek law governed bonds identified in the invitations for the amendments to become effective, it intends, in consultation with its official sector creditors, to declare the proposed amendments effective and binding on all holders of these bonds.

In other words, there are collective action clauses, and if Greece can trigger them, it will. End of story.

Greece has also now explicitly talking about default; as far as I can tell this is the first time it has done that.

The Republic’s representative noted that Greece’s economic programme does not contemplate the availability of funds to make payments to private sector creditors that decline to participate in PSI.

This isn’t quite as drastic as it seems at first blush. Remember that Greece has now said that if it can trigger the CACs, it will. So if more than 66% of bondholders tender into the exchange, then everybody will end up with new bonds, whether they tendered into the exchange or not.

But note that this only applies to the Greek-law bonds. The English-law bonds need a 75% take-up, on a bond-by-bond basis. So it’s possible that the Greek-law bonds will be successfully exchanged, while some or all of the English-law bonds end up in default.

The English-law bonds are ultimately something of a sideshow, except for purposes of Greece’s CDS, where they might well end up being the instruments tendered into the bond exchange. But this new stance from Greece now makes the outcome of the Greek CDS auction very uncertain indeed: if one English-law bond fails to get 75% participation and gets defaulted on, then that bond will certainly become the cheapest bond to deliver into the exchange, and the CDS payout will be much higher than current market prices are anticipating.

My feeling is that this press release is an attempt to maximize the participation of holders of English-law bonds. If they hold out, Greece is saying, then the exchange is very likely to go ahead without them, and they’ll be left behind with nothing to show for it except the prospect of a long and painful court fight. Under the terms of the original press release, Greece kept open the possibility that it might pay hold-out creditors in full. Now it seems to have closed down that possibility. Which makes the upside of holding out much smaller.

Andrew Ross Sorkin weighs in today on Goldman’s conflicts in the takeover of El Paso Corporation by Kinder Morgan, as laid bare in a blistering opinion by Delaware Chancellor Leo Strine. Steven Davidoff has described the decision as demonstrating that “Chancellor Strine is a bold judge, one who is brilliant and willing to make waves” — and so it’s worth extracting some of the more Rakoffian bits of Strine prose.

While Sorkin leads his column with the script that Goldman CEO Lloyd Blankfein was given when he called El Paso CEO Doug Foshee, for instance, he omits the gloss that Strine provides on that script:

Certain Chancery staff have experienced a troubling side effect to reading this evidence: Lionel Richie’s 1980’s treacle, “Hello,” came to mind and is stuck in their heads. See LIONEL RICHIE, Hello, on CAN’T SLOW DOWN (Motown Records 1983) (“Hello!/Is it me you’re looking for?/I can see it in your eyes/I can see it in your smile/You’re all I’ve ever wanted/And my arms are open wide …./And I want to tell you so much I love you ….”).

Similarly, while Foshee officially says that he has “acted at all times in a manner consistent with our values of stewardship and integrity, and always conducted myself in the best interests of El Paso, its employees, and its shareholders”, that has to be read in the context of the way in which Strine utterly skewered him:

At a time when Foshee’s and the Board’s duty was to squeeze the last drop of the lemon out for El Paso’s stockholders, Foshee had a motive to keep juice in the lemon that he could use to make a financial Collins for himself and his fellow managers interested in pursuing an MBO of the E&P business. The defendants defend this by calling Foshee’s actions and motivations immaterial and frivolous.

It may turn out after trial that Foshee is the type of person who entertains and then dismisses multi-billion dollar transactions at whim. Perhaps his interest in an MBO was really more of a passing fancy, a casual thought that he could have mentioned to Kinder over canapés and forgotten about the next day.

It could be.

Strine saves his most acid commentary for Goldman.

The defendants begrudgingly concede that El Paso’s long- standing financial advisor, Goldman, had a “potential conflict” because: (1) it owned approximately 19%, or $4 billion worth, of Kinder Morgan stock; (2) it controlled two of Kinder Morgan’s board seats; (3) it had placed two senior Goldman principals on the Kinder Morgan board who thus owed Kinder Morgan fiduciary duties; and (4) the lead Goldman banker working for El Paso, Steve Daniel, personally owned approximately $340,000 of Kinder Morgan stock.

The phrase “potential conflict” is footnoted; Strine notes drily that “Goldman’s answering brief used the phrase ‘potential conflict’ to describe its position fifteen times.” In fact, as Strine says, this wasn’t a potential conflict at all: instead, the conflict was “actual and potent”.

Goldman’s position — beautifully demolished by Strine — is that it had Chinese walls in place, and that its M&A team was blissfully ignorant of the enormous stake that Goldman had in Kinder Morgan getting El Paso on the cheap. (Never mind the fact that Goldman’s M&A team was led by someone who personally had a $340,000 stake in Kinder. As Foshee himself put it, that’s a conflict “between one person’s brain”.)

But here’s the thing: as Francesco Guerrera points out, if Goldman’s only interest here was getting a nice check for its M&A team, there was an easy and non-conflicted way for them to do that.

This unruly mess wouldn’t have happened had Goldman resigned from El Paso right after the Kinder Morgan approach. Goldman would have probably been hired by Kinder Morgan, earned similar fees and avoided uncomfortable questions about divided loyalties.

Which definitely makes it seem as though the only reason for Goldman to stay on as an El Paso adviser was to ensure that El Paso and Forshee sold themselves for a modest sum to Goldman and its fellow owners of Kinder.

Guerrera adds that “what Goldman did isn’t illegal, just inappropriate in an age in which Wall Street’s morals and behavior are under the public microscope”. But Strine actually goes further than that — he says quite clearly that “the plaintiffs have a reasonable probability of success on a claim that the Merger is tainted by breaches of fiduciary duty”. And Davidoff notes that “Goldman Sachs’s engagement letter with El Paso probably limits its liabilities to no more than $20 million”. It’s entirely possible that Goldman’s actions in this case were both inappropriate and actionable; what’s more, Goldman will probably end up settling the case at some point, for a multi-million-dollar sum.

All of this comes as Nick Dunbar of Bloomberg reports on the numbers involved in Goldman’s shenanigans in Greece.

On the day the 2001 deal was struck, the government owed the bank about 600 million euros ($793 million) more than the 2.8 billion euros it borrowed, said Spyros Papanicolaou, who took over the country’s debt-management agency in 2005. By then, the price of the transaction, a derivative that disguised the loan and that Goldman Sachs persuaded Greece not to test with competitors, had almost doubled to 5.1 billion euros, he said.

The question at this point is surely why any client would ever trust Goldman on anything. Goldman seems to have a habit, here: it recommends a certain course of action, involving a deal which the client is barred from testing in the market. (El Paso wasn’t allowed to shop itself to anybody other than Kinder; Greece wasn’t allowed to check the market price of the swaps which Goldman was selling it, because Goldman said that if Greece did that, the whole deal would be off.)

This is surely the most magical and mysterious aspect of Goldman Sachs: that despite mountains of evidence that its actions are always orchestrated to result in the best possible outcome for Goldman Sachs, its clients still seem to trust it to give excellent and impartial advice in their own best interest. Maybe that’s the key skill that Goldman investment bankers are hired for. Not analytical or strategic expertise, but rather the ability to snow clients and get them to do whatever Goldman wants.

Harry Wilson today outs Allen & Overy’s David Benton as the legal mastermind behind the mess that is sovereign CDS documentation. Benton’s certainly coming under a lot of criticism these days, and not just on the ultra-wonky end of the spectrum from people like me. Even Pimco’s Bill Gross seems to have a beef with these rules — and Pimco’s on the Determinations Committee!

“If I were a buyer of protection on Greece and have seen the result this morning in terms of no protection, then I would be upset,” Gross, manager of the world’s largest bond fund, said on CNBC television of the ISDA’s decision.

So when Wilson says that ISDA’s decision not yet to declare default was “controversial”, he’s not wrong. Here, for instance, is Barry Ritholtz:

Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?

The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.

And Peter Eavis is back with more CDS criticism, too:

One of the decisions of the swaps association on Thursday underscored how swaps can be disconnected from actions that harm investors’ economic interests. As part of the Greek debt deal, the European Central Bank will be shielded against losses on the Greek bonds it holds, a move that relegates, or subordinates, the claims of private creditors who hold the same bonds.

But the swaps association said the plans to subordinate private creditors do not meet the definition of subordination in the swaps contracts, so they do not have to pay out.

All of which says to me that ISDA and Greece have done an incredibly bad communications job here. Because ISDA’s decision was, clearly, the correct one.

The point here, which is easy to miss, is that credit default swaps only get triggered when there’s a real-world event of default. Yes, the deal with the ECB is indeed going to subordinate private-sector bondholders. And yes, Greece is indeed going to fail to make good on its obligations come March 20. There will be an event of default in Greece. But swaps don’t pay out on future events. They pay out on past events. And Greece hasn’t actually defaulted yet: every payment it has promised to make has, to date, been made in full and on time.

Now there are exceptions to this rule. If a government explicitly repudiates its outstanding debt, then that can count as an event of default even before a payment is missed. But Greece hasn’t actually done that. And most of the time, default swaps only pay out when there’s a default. Which is as it should be.

Is that reason for bondholders to be upset, pace Gross? Absolutely not. If you own a credit default swap on Greece, you own a piece of paper worth about 75 cents on the dollar. If you want to realize that 75 cents right now, you can: you can just sell your CDS. If and when the CDS is officially triggered, there will be an auction, and the CDS will be found to be worth roughly 75 cents on the dollar. In that case, you will wind up with 75 cents whether you like it or not.

In other words, when Greece finally defaults, owners of credit protection will be forced to get a payout. Whereas those owners right now have the option: they can take the payout if they want it, or they can hold on to their CDS position if they would rather do that. I don’t see why having that option would make anybody upset.

This is why the CDS market has been so successful: it’s a liquid, market instrument, which prices in expectations of future default. Ritholtz is right that Greece has refused to make good on its future obligations. And as a result, default protection on Greece is extremely valuable. When that future date comes and goes without a bond payment, the CDS will get triggered, and holders of protection will get a lot of money. There’s nothing broken there.

The subordination question is a bit messier, but it’s fundamentally the same idea. Greece has now created two classes of bonds: the ones held by the ECB, and the ones held by private bondholders. There’s nothing in the documentation of those bonds which might indicate the ECB’s bonds are senior to the private sector’s bonds. Right now, they’re all, legally, pari passu.

Again, in future, that’s not going to be the case. Greece is going to privilege the principal and coupon payments to the ECB, while imposing a massive haircut on the payments due private bondholders. That’s both subordination and an event of default. And when it happens, the CDS will get triggered. And that trigger is priced in to the CDS market.

In many ways it’s the genius of the CDS market — at least in theory — that there’s no rush to trigger CDS, because if you know that the instrument is going to get triggered very soon anyway, it’s going to be worth pretty much the same today as it will be when it’s triggered.

That’s my problem with the way ISDA rules cover bonds covered by CACs. Because of technical issues surrounding the availability of deliverables, it’s possible that if you wait for the default to happen, you’ll be too late to get what by rights should be your payout on the bonds. But this is a separate issue from what Gross and Ritholtz and Eavis are worrying about. They seem to think one of two things: either that Greece has already defaulted, and that therefore the CDS should have been triggered by now, or else that a Greek default is so certain at this point that the CDS should have been triggered by now. The first isn’t true. And the second is silly.

Eavis has another point, which is that default swaps are used for a purpose, and that purpose is to hedge against falling bond valuations. (That’s what he means by “investors’ economic interests”.) He is worried that the payout on the bonds might not be entirely in line with the loss of value on the bonds. And that’s a reasonable worry. But it’s also, right now, a pretty theoretical worry. Because in practice, the value of Greek CDS has tracked the value of Greek bonds extremely closely. In other words, even if there are possible problems with them in theory, they seem to have worked OK in practice.

I’ve got a few questions for ISDA about the way that CDS documentation works in the sovereign context in particular, and I’ll be wonking out about this issue further going forward. Because I think that the combination of CACs and CDSs is potentially extremely dangerous. But what I’m emphatically not worried about is ISDA’s decision not to trigger the CDS just yet. That decision was exactly correct. Even Pimco voted for it.

First, apologies for how Greece-heavy this blog is these days. There are other things going on out there, I’m sure. But we’re going through the largest sovereign default in the history of the world, and surprisingly few people — including senior European policymakers and journalists who are covering it professionally — really seem to understand what’s going on.

At the WSJ, for instance, the news story on today’s official ISDA determination (“Greek Deal Won’t Trigger CDS Payouts, Panel Says”) is bad; the blog post about it by Charles Forelle (“ISDA’s Greek Ruling Not the Last Word”) is very good.

And in Europe, the range of sophistication within policymaking circles is even greater. At the lowest, most basic level, one finds a feeling that it’s a Bad Thing if a European sovereign nation were ever to default, and so therefore it would be a good thing if the bond exchange was organized so that there was no official market determination of default. (Never mind that Greece is already in selective default on its bonds, according to S&P.)

At a slightly higher level of sophistication one finds the short-sellers-are-bad crowd, who don’t like CDS because they allow hedge funds to easily bet against countries. If the messy Greek CDS situation helps to reduce the amount of trust that the markets have in sovereign CDS generally, then so much the better, on this view.

And then, finally, there’s Peter Eavis’s conspiracy theory: if the Greek bond exchange goes really smoothly, and the sun rises in the morning and Italian bond yields stay below 5%, then maybe that’s the most worrying outcome of all. Because at that point Greece will have managed to wipe out, at a stroke, debt amounting to some 54% of GDP. You can see how Portugal and Ireland might be a little jealous. You don’t want to make sovereign default too easy — not least because it would do extremely nasty things to European banks’ balance sheets.

That said, Greece has now broken the sovereign-default taboo; many countries both inside and outside Europe have way too much debt; and now that debt relief is an option for politicians to seriously consider, it’s pretty much certain that at some point another European government will end up choosing that option.

So it’s extremely important for European politicians and voters generally to really understand what’s going on here, rather than just a relative handful of financial-market sophisticates. Greece’s default was a drastic move, and Europe has semi-officially said that it was a mistake: once we’re done with Greece, they’ve said, we’re not going to ask any other European country to similarly write down its private debt.

But the cat’s out of the bag now. Greece had no choice but to default. Portugal and Ireland do now have the choice. And while the cost of default is large, so is the cost of carrying a whopping great debt load. It’s up to the leaders and voters of those countries to determine which is the least bad option.

Alea today posts the timeline for physical settlement of credit default swaps, once a credit event has been declared. He doesn’t say why he’s posting it, but the main thing to note is that it’s likely to take a couple of months between (a) the credit event being declared in Greece, and (b) the final settlement of all credit default swaps on Greece.

And that, in turn, reveals a significant weakness in the architecture of CDS documentation. It may or may not be a big deal, this time round. But market participants have already been spooked by the possibility that Greece might be able to default without triggering its CDS at all. Now they can add to that another worry: that Greece might be able to default in such a manner as to leave the ultimate value of the CDS largely a matter of luck.

The way that CDS auctions work, you start with a credit event. Then, using an auction mechanism, the market works out what the cheapest bond of the defaulting issuer is worth. If it’s worth, say, 25 cents on the dollar, then people who wrote credit protection end up paying 75 cents to the people who bought protection: that’s equivalent to the people who bought protection getting 100 cents on the dollar, and handing their bonds over in return.

With Greece, however, the bond exchange is going to complicate things — a lot. Remember that it has a natural deadline: March 20, when a €14 billion principal payment comes due. If Greece’s old bonds haven’t been exchanged for new bonds by that point, then things will get even uglier, and even more chaotic, than anybody’s expecting right now. So it’s very much in Greece’s interest, and Europe’s more generally, to have everything wrapped up by March 20. Bondholders too, truth be told — they hate uncertainty.

But then there’s the CDS holders. In the best-case scenario for Greece and Europe and bondholders, every €1,000 of old Greek bonds will get converted to new bonds with a face value of just €315. Those bonds will probably trade at about 30% of face value, which means the new-Greek-bond component of the exchange will be worth about 10 cents for every dollar in face value of old Greek bonds that you might currently hold. Add in another 15 cents of EFSF bonds, and the total value of the exchange will be about 25 cents on the dollar, which is why people are talking about a 75% “present value haircut”.

The important thing, here, is that Greece is issuing new bonds worth around 10 cents on the dollar, while the EFSF is issuing new bonds worth around 15 cents on the dollar. The structure of the new Greek bonds is secondary: these ones involve a nominal haircut of 68.5%, and a market price of about 30 cents on the dollar. But theoretically, Greece could have constructed bonds with a significantly higher coupon and a bigger nominal haircut — maybe the haircut would be 85%, with the bonds trading at 67 cents on the dollar. Bondholders would still receive about €100 worth of new Greek bonds for every €1,000 of old Greek bonds they hold. But instead of the new Greek bonds trading at 30 cents, they’d trade at 67 cents.

Why does it matter what the nominal price of the new Greek bonds is, so long as the total package, including EFSF bonds, is worth about 25 cents on the dollar? Economically speaking, it doesn’t. But for the purposes of the CDS auction, it matters a great deal.

The reason is that the key number in the auction is the nominal value of the cheapest-to-deliver Greek bond — that’s the price at which the auction clears. And here’s the rub: this auction is going to take place after March 20, after the old Greek bonds have been exchanged into new securities. Because Greece intends to use collective action clauses to change the terms of all its outstanding bonds, even if they’re not tendered into the exchange, there effectively won’t be any old bonds in existence by the time the CDS auction happens. The only outstanding reference securities will be new bonds.

In the auction, market participants will not be bidding on the value of the package that is being offered in return for every old bond. The new EFSF bonds are obligations of the EFSF, for instance: they’re not obligations of Greece, and they have no place in a Greek CDS auction.

The way that CDS auctions are meant to work is that once a borrower defaults on its debt, that defaulted debt continues to be traded in the market, and its value then determines the amount that credit default swaps need to pay out. But in this case, Greece’s defaulted debt might well not continue to be traded in the market. In which case, when traders need to find a cheapest-to-deliver bond to bid on in the CDS auction, they’re going to have to use one of the new bonds, rather than one of the old ones.

And now you can see why the nominal price of the new Greek bonds is so important. Right now, it seems that they’ll be trading at a nominal price of about 30 cents on the dollar, which is close (ish) to the current market price of the old Greek debt. But there’s no particular reason why that should be the case. If Greece had gone for an 85% nominal haircut rather than a 68.5% nominal haircut, then the nominal price of the new Greek bonds would be 67 cents on the dollar — and anybody who wrote credit protection on Greece would only have to pay out 33 cents on the dollar rather than 70 cents on the dollar.

In other words, Greece’s CDS really aren’t protecting holders of Greek bonds at all — or if they do, it’s more a matter of luck than of law. When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds.

What this means is that the CDS architecture is broken, and can’t cope with collective action clauses. And as a result, according to the hedge fund manager who tipped me off to the whole problem, “this Greece CDS imbroglio might be the final blow for sovereign CDS as a product.”

Now there is a possible solution here: ISDA could try to decree, somehow, that the total package bondholders receive in return for their old bonds will count as a deliverable security for the purposes of the CDS auction. Bundle up the new bonds, the EFSF bonds, the GDP warrants, everything — and that bundle can be bid on in the auction, to determine where the CDS pays out. That would be fair and right. But the problem is, it might not be legal. There’s really nothing in the ISDA CDS documentation which explicitly allows that to happen.

The whole point about credit default swaps is that they’re meant to behave in a predictable manner in the event of default; one thing we know for sure about Greece is that the behavior of its CDS is going to be anything but predictable. We don’t even know for sure whether they’ll be triggered, let alone what they’ll be worth if and when they are.

Now there are a lot of people, among them European policymakers, who would actually be quite happy if the Greek default killed off the sovereign CDS market as a side effect. But I actually believe that sovereign CDS, when they work, are rather useful things. It’s just that Greece is having the effect of showing that they don’t necessarily work. And if you can’t be sure that they’ll work when triggered, there’s really no point in buying them at all.

Back on February 17, the European Central Bank sprinkled its magical pixie dust on its Greek sovereign bonds, with the effect that they effectively ended up exempt from the restructuring and haircut being inflicted on everybody else. I wasn’t very excited about this development at the time:

On a conceptual level, it makes sense that the Troika — of which the ECB is a third — might be granted immunity from haircuts, in return for providing new money to Greece. On a legal and practical level, however, this is ugly — and you can be quite sure that it’s only going to get uglier from here on in.

Today, we’re beginning to get a hint of the messiness that this decision caused.

First, there’s a formal question which has been put to ISDA’s Determinations Committee, asking whether the ECB magical pixie dust, combined with the passage of the Greek law to allow the haircut, doesn’t in itself constitute a credit event under ISDA rules.

The question takes the form of a single 179-word sentence, which some lawyer somewhere probably thinks is very clever. But here’s the idea: the two events together have effectively cleaved the stock of Greek bonds into two parts, with one part (the bonds owned by the ECB) being effectively senior to the other part (the bonds owned by everybody else). This is known as Subordination, and Subordination is a credit event under ISDA rules.

Now there’s no doubt that the private sector’s Greek bonds are de facto subordinate to the ECB’s Greek bonds now, and that they weren’t subordinate a couple of weeks ago. But so far there’s nothing de jure about this subordination — there’s no intrinsic reason why bonds with CACs, for instance, should be subordinate to bonds without CACs. So my guess is that this request is going to go nowhere, and/or get overtaken by events.

But now there’s news that another European institution has managed to get its hands on the ECB’s magical pixie dust.

The European Investment Bank, owned by the 27-member bloc, is getting exemptions from Greek debt writedowns in the same way as the euro area’s central bank, according to two regional officials familiar with the matter.

The European Central Bank negotiated a deal to avoid the 53.5 percent loss on principal that’s costing private investors as much as 106 billion euros ($143 billion). The EIB, which unlike its Frankfurt-based counterpart represents the entire European Union, also owns Greece’s debt and is sidestepping the so-called haircut in the same way, said the officials, who declined to be identified because the plan isn’t public.

While the ECB exemption was understandable, on the grounds that the ECB was part of the Troika and the Troika is putting up new money here, an EIB exemption is less so. The EIB is not putting money into this latest Greece bailout. Indeed, it represents countries like the UK which are quite explicitly removing themselves from any such thing.

Now, admittedly, the European Commission is a member of the Troika, and the European Commission is the executive body of the European Union, and the European Union collectively owns the European Investment Bank. So this decision is, as the lawyers would say, colorable. But if the decision to exempt the ECB from the Greece haircut was ugly, then the decision to exempt the EIB is, at the margin, even uglier. I’m not saying it’s the wrong decision, necessarily. After all, sovereign restructurings necessarily have an ad hoc, make-it-up-as-you-go-along element to them.

Indeed, if the ECB’s magical pixie dust means that there’s substantially more EU support for this deal, then it might well be worth spreading it around a bit. But at the same time, predictability and consistency are important as well. And both of those seem to have gone out the window at this point. I wouldn’t be at all surprised if ISDA’s Determinations Committee just said “enough already” and declared an event of default. Because in recent weeks private-sector bondholders have been treated in an extremely cavalier manner. And those decisions have consequences.

If you go to the official website for the Greek bond exchange, greekbonds.gr, you can now find an actual official document! The rest of the website, it says, “will be available shortly”, whatever that’s supposed to mean.

The document gives us most — but not all — of the information that bondholders will need in order to be able to decide whether or not they’re going to tender their bonds into the exchange. It’s written in very dense legalese — the first sentence is 70 words long, with only one comma — so let me try to pull out the important bits.

This is complicated, as you might imagine. It makes a significant difference (a) what bonds you hold, whether they’re Greek law or English law, and also (b) where you live, whether it’s in Europe or in the US. (There are also, it turns out, Swiss-law bonds as well, which have their own very special treatment.) But at the end of the day, most bondholders are going to get pretty much the same things when they tender their bonds; you’ll forgive me for ignoring some of the more niggly stuff.

Firstly, they’re going to receive new Greek bonds, maturing in 2042. It doesn’t matter whether the bonds you’re holding mature on March 20, or whether they mature in 30 years’ time — everybody gets the same new long-dated bonds, according to the face value of what they now own. In other words, the value of Greek bonds right now is wholly a function of what their face value is, and has nothing to do with their coupon or their maturity date.

The new Greek bonds have a step-up coupon: 2% through 2015, then 3% through 2020, then 3.65% in 2021, and then 4.3% from 2022 through 2042. Bondholders will receive new bonds with a face value of €315 for every €1,000 of old bonds they hold. (Again, remember that it’s face value which matters here, not market price.) What’s the market price of the new bonds going to be? Not very much; my guess is that they’ll trade at roughly 40% of face value. Which means that the “NPV haircut”, as far as the new Greek obligations are concerned, is somewhere on the order of 87%.

But bondholders will get more than just Greek bonds; they will also get new EFSF notes. The new EFSF notes come in two flavors: one-year notes and two-year notes; their face value is going to be 15% of the face value of the tendered bonds. The working assumption right now is that they’re going to be worth €150 for every €1,000 of bonds tendered: in other words, if you look at the value of what bondholders are going to be receiving in exchange for their bonds, it’s going to be split roughly 50-50 between Greek bonds and EFSF notes.

We don’t know that for sure, however, because for reasons I don’t pretend to understand, the coupon on the EFSF notes is still undetermined; we’re just told that it will be revealed on the Issue Date. (And no, we’re not told what the Issue Date is going to be.) In any event, bondholders in the US won’t receive EFSF notes at all; instead, they’ll receive “the cash proceeds realized from the sale of the EFSF notes they would otherwise have received”.

Finally, bondholders will receive GDP warrants of some description, which are the vaguest thing of all. “The GDP-linked Securities will provide for annual payments beginning in 2015 of an amount of up to 1% of their notional amount in the event the Republic’s nominal GDP exceeds a defined threshold and the Republic has positive GDP growth in real terms in excess of specified targets.” How much are these warrants going to be worth? The working assumption has to be zero, at least until we get some numbers for the minimum GDP and GDP growth that Greece needs in order to pay out on them.

When bondholder tender their old bonds to receive new ones, two things will happen. First, the old bonds will have been accruing interest since their last coupon payment. That interest will not be paid out in cash; instead, it will be paid out in the form of six-month zero-coupon EFSF notes. Why? This is just stupid nickel-and-diming: is there any reason why the EFSF is better off paying that money in six months rather than just paying it now?

Second, the bondholders will almost certainly vote, when they tender their old bonds, to bail in everybody who doesn’t tender their bonds, and force them to accept the same deal. That’s the Collective Action Clause (CAC) that you might have been reading about.

Will the CACs be used? Will the exchange even happen? That depends entirely on how many bondholders decide to tender into the exchange. (We’ll assume for the time being that if you tender, you’ll also consent to implementing the CACs; there’s no obvious reason why anybody would do the former without doing the latter.)

In order for the CACs to even come into existence, let alone be triggered, Greece needs two-thirds of its old bonds to be tendered. If it doesn’t reach that threshold, then the whole exchange is a bust and won’t happen at all. Indeed, Greece says in this release that it won’t go ahead with the exchange unless it gets at least 75% participation. If fewer than 75% of Greece’s bondholders tender into the exchange, then Greece won’t accept those tenders, and we’ll have a chaotic default.

If more than 90% of Greece’s bonds are tendered, then the exchange will be a success, the CACs will be triggered, and Greece’s old bonds will be replaced by new bonds. And because the CACs will be triggered, you can be sure that CDS will be triggered as well.

And what happens if the participation rate is between 75% and 90%? That’s vaguer. In that case, says the press release, “the Republic, in consultation with its official sector creditors, may proceed to exchange the tendered bonds without putting any of the proposed amendments into effect”. Which seems to me to say that if you tender into the exchange then you’ll get new bonds, and if you don’t tender into the exchange then, um, well, you’ll be left with your old bonds. The implied threat here is that Greece will pay out on its new bonds but won’t pay out on its old bonds — and bondholders who didn’t participate in the exchange will be left with claims on the Greek government which they’ll be lucky to ever collect on. Of course the CDS would be triggered in that case, too — it would be a clear-cut default. But Greece would have a large outstanding stock of unpaid debt for the foreseeable future.

The idea here is to prevent would-be free-riders from holding out in the exchange, refusing to tender their bonds on the basis that if they hold out, then they’ll just get bailed in by the CACs anyway. That strategy works if there’s more than 90% participation, but it becomes very dangerous if there’s less than 90% participation.

Will this strategy be enough to get 90% of Greece’s bondholders to tender into the exchange? I suspect it might. And of course if the takeup is between 75% and 90% Greece still has the option of exercising the CACs and bailing everybody in anyway. (Note that “may” in the press release which I bolded.) Chances are, that’s what it would do: it’s better for Greece to have one series of bonds outstanding which it isn’t in default on, rather than lots of series of bonds outstanding where it’s in default on most of them. But we won’t know for sure until after the results of the bond exchange are made public. And we won’t even know what bondholders are thinking with respect to the terms of the exchange until we get more details on the GDP warrants and the coupon on the EFSF notes. When will that come? Your guess is as good as mine.

Are you alarmed by today’s headline in the NYT saying, disturbingly, that the “Greek Crisis Raises New Fears Over Credit-Default Swaps”? Don’t be. The article in question turns out to be a solid 770-word explainer by Peter Eavis in which he gives the final word to Stanford’s Darrell Duffie, saying that any such fears are “small potatoes”.

But at the beginning, Eavis talks about how European policymakers “fear that payments on the swaps might set off destabilizing chain reactions through Europe’s financial system”; later on, he writes that “the swaps will also come under heavy fire if there is any indication that activating the Greek instruments is leading to stress in the financial system”. It would have been nice if he’d named one of those policymakers, or explained what exactly their fears might be.

How, exactly, would a CDS trigger lead to stress in the financial system? After all, as Eavis concedes, every time banks’ balance sheets have been examined, regulators have found essentially nothing in the way of unhedged CDS exposures.

There is the possibility of counterparty risk — a spectre Eavis raises only to dismiss it. In order for counterparty risk to be a problem, you need two things. First, you need a bank with a very large unhedged CDS exposure to one single name — the kind of position I’ve never seen any bank have. (Remember here that credit default swaps were invented for banks to sell down their loan exposure, not to increase it.) And then, on top of that, you need jump risk: the risk that the single name in question will suddenly default, forcing the bank to pay out a huge amount of money at once.

But in Greece, there is no jump risk at all. Because a default has been priced in for months, any bank which has written default protection on Greece has had to steadily post more and more margin against that position. When Greece officially defaults at the end of March, there will be an auction to determine the clearing price of the swaps, and the margin will simply get transferred to the bank’s counterparty. The bank will probably need to make no payment at all.

In other words, counterparty risk on sovereign CDS is probably a non-issue, but it’s certainly a non-issue in Greece.

So what are the “new fears” of Eavis’s headline? I’m beginning to think that in fact the fears are not that the swaps will get triggered, causing some kind of financial calamity, but rather that they won’t be:

Some chance remains that the exchange could be done voluntarily, avoiding a default swap event. That outcome would most likely prompt a torrent of criticism that the swaps did not cover holders against losses, as they were intended to.

“The whole nature of the C.D.S. contract would be called into question,” said Richard Portes, professor of economics at the London Business School.

As Eavis says, the chance of the swaps not being triggered is extremely small, at this point. But it’s higher than the chance that the trigger will cause some kind of financial-market calamity. It’s possible — unlikely, but possible — that Greece will get such a large acceptance rate on its exchange offer that the size of the holdouts would be very small indeed. If that happens, it’s also possible-but-unlikely that Greece will choose to simply continue paying those holdouts in full, rather than defaulting on them or trying to bail them into the deal through CACs. If both of those possible-but-unlikely things happen, then it’s definitely possible ISDA would determine that there was no credit event. But we’re so far down the chain of speculation at this point that these things are really not worth worrying about; the unanimous consensus in the market is that there will be a default, in March, and that the CDS will get triggered.

The thing that really worries me is not the CDS market at all. In fact, for all that credit default swaps were an intrinsic part of the financial crisis, the traded market in CDS has been remarkably robust. It certainly withstood the bankruptcy of Lehman without any trouble, both in terms of counterparty risk relating to Lehman’s own positions and in terms of CDS on Lehman being triggered when the bank failed.

Rather, what worries me is that the vast majority of people reading this article in the NYT will see the headline about New Fears, and if they skim the article will just see a bunch of concerns and some quotes from people on both sides. In other words, Eavis’s article is to a large degree self-fulfilling: people will read it and start being worried about the CDS market all over again, especially if — like 99% of the population — they don’t really understand the CDS market at all, and have no particular need or desire to get into the nitty-gritty. All they know, or think they know, is that credit default swaps are Dangerous Complex Derivatives, and that the Greek crisis is making them more dangerous still.

Meanwhile, Eavis never touches on what I’m pretty sure is the real reason that European policymakers are worried about a CDS trigger. A lot of people have been asking me about the Greek deal in recent days and weeks, and I get a lot of questions like the one I was asked yesterday by Amanda Lang, who asked whether default was in fact inevitable and whether Greece was just putting it off with this deal, kicking the can down the road. A lot of otherwise very well-informed people still think that this bailout is like previous bailouts, designed to avert a default. When in fact a huge default is right at its very heart. When the CDS get triggered, it’s going to be very obvious that this is indeed a Greek default. That’s something which bond market professionals are acutely aware of, but it hasn’t really sunk in to the broader popular consciousness.

If the Greeks and the Europeans can structure a deal where the credit default swaps aren’t triggered and the bondholders voluntarily swap their old bonds for new bonds, then it’s actually possible that this misunderstanding could continue well past the bond exchange, to the point that the broad public thinks that we’ve just seen another bailout, and misses the footnote that the bailout was accompanied by the single largest bond default in the history of the world.

If all goes according to plan, this is going to be an orderly bond default, to be sure — in contrast to the very disorderly defaults we’ve seen in recent years in countries like Argentina and Ecuador. But make no mistake: Ecuador Greece owes €14 billion to its bondholders on March 20. It is not going to make that payment, and instead bondholders who are currently owed 100 cents on March 20 will find themselves instead with a mixture of securities worth maybe 26 cents on the open market. When the CDS get triggered, that fact is going to get hammered home. Because although it has long been priced in to the market, it still isn’t broadly understood.