Felix Salmon

Back in November, Alison Frankel had a very sensible and clear-eyed analysis of the lawsuit which a Cayman-based hedge fund, Fir Tree, is bringing against, essentially, the government of Ireland. In short, Ireland has sovereign immunity, so, no dice. Sorry, better luck next time.

Since then, there’s been no real new news in the case. But for some reason the Economist has decided all of a sudden that this is a terribly important case which “eviscerates law in New York” and which raises a host of worries:

If America’s legal system cannot be relied on for deals done in America, it will become a less attractive place to do business. Borrowing costs may rise, which could prompt non-American companies to take business elsewhere. At the very least, terms will be tweaked.

To make a long story short, the saga here is that Fir Tree wound up buying Anglo Irish debt obligations which were written under New York law. But then Anglo Irish got nationalized, so Fir Tree no longer has a simple commercial contract in New York, facing a bank: it’s now having to line up with other bank creditors of the Irish government.

That’s not a great outcome for Fir Tree, but it’s simply what happens when a bank gets nationalized. Fir Tree would have been no better off had Anglo Irish simply been left to go bust, which was the only other alternative. And any time anybody lends money to a foreign company, they know there’s a risk of nationalization — especially when that foreign company is a bank.

The law in New York, it’s important to emphasize, has not been eviscerated at all. The Foreign Sovereign Immunities Act is the law in New York, it has been the law in New York for as long as anybody can remember, and anybody writing contracts in New York knows about it. Does the existence of the FSIA make New York “a less attractive place to do business”? Not really: it’s been around for a long time, with no visible effect on New York’s attractiveness as a commercial center.

What’s more, you can’t “tweak” the terms of a contract to get around the risk that a foreign company will become nationalized and thereby subject to the FSIA. That’s a known risk for any lender, and there’s nothing anybody can do about it. Moving the contract to some other jurisdiction wouldn’t help, either: the world’s major commercial centers all have laws giving foreign sovereigns immunity on a very broad front. New York is in no way exceptional in that.

As we’re seeing in the saga of Elliott vs Argentina, any attempt to sue a foreign sovereign in New York court is going to be extremely fraught and difficult at best. Some market fundamentalists might have a problem with that: if “corporations are people too”, then why shouldn’t entire countries be people as well? But for the time being, and for the foreseeable future, foreign sovereigns are special in the eyes of the law. And that’s not an evisceration of anything.

Earlier this month I wrote about Argentina, Elliott, and the pari passu war — the legal fight between New York hedge funds and the country of Argentina over bonds which Argentina defaulted on almost a decade ago.

The latest development in the case is that Elliott has now filed its own 89-page brief. There’s some smart legal argument in there, as you’d expect from Ted Olson. (Elliott has never been a company to scrimp on legal fees.) But the most surprising bit, at least to me, is that Elliott is quite explicitly distancing itself from its own pari passu argument.

Elliott more or less invented the pari passu argument, in 2000, when it was fighting a similar case against Peru. But this time around, Elliott’s slicing up the pari passu clause very thinly, and discarding the pari passu bit of it entirely.

Here’s the clause that Argentina agreed to when it issued its original debt:

The Securities will constitute… direct, unconditional, unsecured and unsubordinated obligations of the Republic and shall at all times rank pari passu and without any preference among themselves. The payment obligations of the Republic under the Securities shall at all times rank at least equally with all its other present and future unsecured and unsubordinated External Indebtedness.

And here’s Elliott, parsing it:

That pari passu clause is not at issue here… The relevant clause is the second sentence, in which Argentina promises that it will ““rank”” ““payment obligations”” under the FAA Bonds ““at least equally”” with obligations under its other ““unsubordinated External Indebtedness.”” To distinguish this undertaking from the irrelevant pari passu clause in the previous sentence, Appellees refer to it as the ““Equal Treatment Provision.””

It’s really hard to see how the pari passu clause could be irrelevant in this case while it was relevant in the Peru case, but I’m sure the Second Circuit doesn’t care about that. The important thing, here, is whether, pared down to a single sentence, what Elliott is now calling the Equal Treatment Provision can support a far-reaching court order which doesn’t just encompass Argentina, but also binds the trustees acting on behalf of the holders of Argentina’s new bonds.

After all, the important question in this case is whether the Southern District judge, Thomas Griesa, can slap an injunction on innocent bondholders of Argentina, many of whom took a 70% haircut on their original debt, just to satisfy the debts of creditors who took no haircut at all. That’s a very drastic remedy, and Olson really needs his 89 pages to try to persuade the Second Circuit that such a remedy is somewhere to be found in that one slender sentence.

That said, Elliott has the wind behind it in this case, for two reasons. First is the fact that Griesa is Griesa — a genuinely venerable judge and one whom the Second Circuit will have no particular appetite to overturn. As Elliott puts it,

It is difficult to conceive of any case in which deference to the discretion of the district court is more appropriate than it is here. The same district judge, with nearly three decades of experience on the federal bench, presided over dozens of similar lawsuits against Argentina for more than one of those decades. He has in-depth familiarity with the parties, counsel, and facts, and he has borne witness to virtually every development in the evolving disputes arising from Argentina’’s 2001 default. He has extensively examined the arguments and written more than 100 opinions and orders, many of which favored Argentina.

It’s true that Griesa has owned this case from day one, and that it’s going to be almost impossible for anybody on the Second Circuit to challenge the depth of his Argentine knowledge. On the other hand, Griesa’s orders (here here here) are slim: for all that he took his time delivering them, most of the legal reasoning is left implicit. The Second Circuit really has no choice but to work out its own opinion from first principles.

More interestingly, Elliott’s brief comes just as an international legal nightmare surrounding the nationalization of Argentine oil company YPF is about to begin. Argentina’s decision to nationalize YPF was bad enough on its own, but from a timing perspective you can be sure there were quite a few facepalms at the Cleary Gottlieb offices. The Second Circuit sees its main job as upholding New York’s status as a protector of contractual rights, and Argentina is trampling all over those rights in as public a way as it possibly can. That’s going to make a decision in favor of Argentina that much more difficult for the appeals court.

So the final decision really could go either way. I’ve got a $5 bet with Reynolds Holding on this: I’m taking Argentina, he’s taking Elliott. He’s much more of a lawyer than I am, of course. But I have politics on my side — the United States is arguing siding with Argentina. Which has got to count for something.

A lot of people were looking forward to Richard Koo deliver his paper at INET last week; it comes with associated slides, here. Koo is the intellectual father of the idea of the balance-sheet recession — an idea which was born in Japan, has increasingly been adopted in the US and the UK, and which is now gaining traction in the Eurozone.

Koo’s diagnosis that Europe is in a balance-sheet recession, which he defines as a post-bubble-bursting state of affairs where individuals and companies choose to pay down their debts rather than borrow money, even when interest rates are at zero. That certainly seems to be the problem in Spain; Koo’s charts can be hard to read, but what you’re seeing here is a massive borrowing binge by the Spanish corporate sector — the dark-blue line — suddenly turning into net savings after the crisis hits. And to make matters worse, Spanish households — the red line — did exactly the same thing. As a result, the government had to run a massive deficit after the crisis; the four lines always have to sum to zero.

In this kind of a recession, monetary policy — reducing rates to zero — doesn’t work. And tax cuts don’t work either: they just increase household savings. You need government spending, at least until the economy has warmed up to the point at which companies and individuals start borrowing again. And the good news is that in a balance sheet recession, government spending is pretty much cost-free, since interest rates are at zero.

That’s the good news in Japan and the US and the UK, anyway. But it’s not the case in Spain. This is a big problem with the single currency, as Koo explains: it encourages capital to flow in exactly the wrong direction.

When presented with a deleveraging private sector, fund managers in non- eurozone countries can place their money only in their own government’s bonds if constraints prevent them from taking on more currency risk or principle risk.

In contrast, eurozone fund managers who are not allowed to take on more principle risk or currency risk are not required to buy their own country’s bonds: they can also buy bonds issued by other eurozone governments because they all share the same currency. Thus, fund managers at French and German banks were busily moving funds into Spanish and Greek bonds a number of years ago in search of higher yields, and Spanish and Portuguese fund managers are now buying German and Dutch government bonds for added safety, all without incurring foreign exchange risk.

The former capital flow aggravated real estate bubbles in many peripheral countries prior to 2008, while the latter flow triggered a sovereign debt crisis in the same countries after 2008. Indeed, the excess domestic savings of Spain and Portugal fled to Germany and Holland just when the Spanish and Portuguese governments needed them to fight balance sheet recessions. That capital flight pushed bond yields higher in peripheral countries and forced their governments into austerity when their private sectors were also deleveraging. With both public and private sectors saving money, the economies fell into deflationary spirals which took the unemployment rate to 23 percent in Spain and to nearly 15 percent in Ireland and Portugal.

With the recipients, Germany and Holland, also aiming for fiscal austerity, the savings that flowed into these countries remained unborrowed and became a deflationary gap for the entire eurozone. It will be difficult to expect stable economic growth until something is done about these highly pro-cyclical and destabilizing capital flows unique to the eurozone.

The solution to this problem is eurobonds. If all the eurozone countries funded themselves jointly and severally, then the yields on European government debt would be very low, and there would be no fiscal crisis in Spain.

But that’s not the solution that Koo provides to the problem that he quite correctly diagnoses. Instead, he said at the INET conference that the way to bring Spanish government bond yields down would be to massively decrease the number of people allowed to buy Spanish bonds.

This doesn’t make any sense to me at all. After all, in any market, the greater the number of potential buyers, the higher the price. But I’ll let Koo try to explain:

Eurozone governments should limit the sale of their government bonds to their own citizens. In other words, only German citizens should be allowed to purchase Bunds, and only Spanish citizens should be able to buy Spanish government bonds. If this rule had been in place from the outset of the euro, none of the problems affecting the single currency today would have happened.

The Greek government could not have pursued a profligate fiscal policy for so long if only Greeks had been allowed to buy its bonds, since private-sector savings in the country was nowhere near enough to finance the government’s spending spree…

The new rule will also resolve the capital flight problem by preventing Spanish savings from flowing into German Bunds. This will prompt Spanish fund managers facing private sector deleveraging to invest in Spanish government bonds, just as their counterparts in the US, UK or Japan must buy bonds issued by their own governments. That would allow Spanish government bond yields to come down to UK—if not to US—levels. With low bond yields and high bond prices, talk of a sovereign debt crisis would also disappear.

It’s absolutely true that a lot of Spanish fund managers, in a flight-to-quality trade, are buying up German and Dutch government bonds. It’s also true that Koo’s proposed rule would prevent them from doing that. But it’s emphatically not true that if they couldn’t buy German or Dutch government bonds, they would buy Spanish government bonds instead.

I asked Koo about this, in Berlin, and the conceptual problem quickly emerged. On the one hand, Koo is careful not to say that he wants fully-fledged capital controls preventing Spanish fund managers from investing abroad at all. He’s confining his proposal just to government bonds, and is not including corporate bonds, equities, structured credit, or anything else that Spaniards can currently invest in. But, he still thinks that this one rule would, single-handedly, take the 6% of GDP that the Spanish private sector is currently saving, and divert it directly into the Spanish government bond market, sending yields there plunging.

It wouldn’t.

The fact is that when money flows into US Treasuries or JGBs or Gilts during a balance-sheet recession, that has absolutely nothing to do with the fact that they’re government bonds, and absolutely everything to do with the fact that they’re the dollar- or yen- or pound-based securities with the lowest perceived credit risk. If you ban Spanish institutional investors from investing in Bunds, then they’ll just buy something else with extremely low credit risk instead — AAA-rated corporate bonds, perhaps, or covered mortgage bonds from somewhere in the north, or some other kind of highly collateralized structured credit instrument. None of those things might have quite the degree of liquidity that Bunds can offer, but they’re still safer than Spanish government debt right now.

Koo is absolutely right that the flow of savings out of Spain is doing absolutely gruesome things to the Spanish economy: you can’t possibly grow when your companies and households are paying down debt, and all your national savings are fleeing the country. So maybe there’s a case for fully-fledged capital controls. But Koo’s weak-tea version would only serve to decrease, rather than increase, demand for Spanish government bonds. Their price would go down, their yields would go up, and Spain would be in an even worse position than it’s in now.

Anna Gelpern puts it well: “for the small but committed contingent of pari passu pointy heads, this is WorldCupOlympicMarchMadnessSuperBowl.” I’m one of the contingent, and I’ve been actively enjoying myself reading various appeals and amici briefs in the case of Elliott Associates vs Argentina. (Technically, it’s not Elliott Associates but rather NML, an Elliott sub-fund, but make no mistake: this is very much a fight between Argentina and the most famous vulture fund in the world.)

Elliott, which is run by the billionaire Republican activist Paul Singer, has suffered a rare and public loss with respect to its Argentina strategy. It bought up Argentine debt around the time the country defaulted, and then refused to enter into the country’s bond exchange, taking its chances in U.S. court instead. That, in hindsight, was a mistake: Argentina’s new bonds, turbo-charged with GDP warrants, performed extremely well. While its defaulted debt has gone absolutely nowhere.

When Elliott started litigating its defaulted debt a decade ago, it quite explicitly told the judge in the U.S. Southern District, Thomas Griesa, that it wouldn’t wheel out the most notorious and legally dubious weapon in its arsenal: the pari passu argument it used to devastating effect against Peru in 2000. In 2003, indeed, Argentina’s lawyers asked the court for a declaration that the argument was legally bonkers; the only reason that Griesa didn’t provide that declaration was that Elliott Associates — in line with all the other holdout creditors — said that it had no intention of making the argument, “at any time in the near or distant future”.

In fact, Elliott was just playing the waiting game — waiting, that is, for 91% of the other creditors to go away, persuaded by Argentina to accept its exchange offer. And then, after a decent amount of time — five years — it suddenly decided that it was going to attempt to use its rather odd pari passu argument after all.

Waiting that long held dangers, since it smells of what lawyers call “laches” — unreasonable delay in making a claim. But it was also quite smart, since at that point Elliott had been fighting Argentina in front of Judge Griesa for a decade, and Griesa was officially Fed Up with the whole thing and just wanted to make it go away.

Griesa’s orders (here here here) are notable for their lack of legal reasoning: Griesa is throwing his hands in the air, here, and basically punting the whole issue up to the appeals court. Each one is very short, certainly in comparison to the long, compelling, and clearly-argued amici briefs, let alone Argentina’s masterful, 84-page response. After reading that, and the briefs from the Justice Department and The Clearing House , it’s basically impossible to see how Griesa’s order can possibly be upheld on appeal.

It’s hard to count the number of reasons why Griesa’s ruling doesn’t make sense, but it’s worth running down a few of them. For one thing, the whole thing is based on the “ratable payment” reading of the pari passu clause — that, in the words of NYU law professor Andreas Lowenfeld, “a borrower from Tom, Dick, and Harry can’t say ‘I will pay Tom and Dick in full, and if there is anything left over I’ll pay Harry’.” Unfortunately, that’s exactly what the borrower can do. If I owe money to my landlord and to my credit-card issuer and to my brother-in-law, it’s up to me which of them I repay, and in which order. All those creditors might have legal recourse if I don’t pay them. But the landlord can’t claim the money I’m paying to my brother-in-law, nor vice-versa.

In this case, Argentina is paying the holders of its new bonds, or, to be precise, it’s paying the trustee who accepts money on their behalf. Once it has transferred money to the trustee, that money no longer belongs to Argentina: it belongs to the new bondholders, the people who accepted a large haircut on their debt as part of Argentina’s bond exchange. What’s scary about Griesa’s order is that he’s ordering and injunctioning not only Argentina, but also the innocent bondholders of Argentina’s new debt. It’s almost impossible to see why they should be paying off Elliott, especially since Elliott wants to be paid all principal and interest payments on its bonds, sans any kind of haircut at all. That doesn’t sound very pari passu to me, if all the other bondholders have taken a 70% haircut.

The problem for Elliott, here, is that it rushed, very soon after Argentina defaulted, to convert its Argentine bonds into court judgments.* That’s easy: Any bondholder who has been defaulted on can become a judgment creditor pretty easily. But becoming a judgment creditor also happens to be the remedy, in the bond documentation, if Argentina violates the pari passu clause. (Which, incidentally, no one knows what it means.) Griesa, in going after the trustee for other Argentine creditors, is going well beyond the letter of the contract, just because that seems to be the only way of getting Argentina’s attention.

Certainly Argentina has no intention of paying Elliott anything. The country’s view of Elliott is that it’s an annoyance, which is causing it to rack up millions of dollars in legal expenses. And as a result, Griesa’s view of Argentina is that while it will happily send expensive lawyers to appear in front of him on a regular basis, it will never actually pay the plaintiffs, no matter what he rules. Which is why, I think, he finally cracked and issued this pari passu ruling: it was the only way he could think of to get Argentina’s attention.

The ruling doesn’t make a lot of sense. For one thing, it requires that Elliott will suffer “irreparable harm” if it isn’t paid. But of course the harm here isn’t irreparable: it’s just money. You pay Elliott money, the harm goes way. That’s pretty much the definition of reparable harm. And then there’s the fraught sovereign-immunity aspect of everything: Griesa’s ruling flies in the face of the Foreign Sovereign Immunities Act, which for obvious reasons the U.S. and most other countries are big fans of. Argentina did waive its sovereign immunity in its original bond issue, but the degree to which that’s even really possible is far from settled under case law.

All of which is to say that Reynolds Holding is wrong when he says that Elliot has “shown it’s possible to win against debtor nations”. Elliott has been a judgment creditor of Argentina for a decade now, and it’s still a judgment creditor: Griesa is a judge, and he can’t ultimately do much more than hand down judgments. The difficult bit has never been getting a court to rule that you’re owed money: that’s the easy bit. The difficult bit is actually collecting on that judgment. And the base-case scenario here is that Elliott is not going to collect.

In fact, the sovereign-debt world is probably a little bit relieved that the Court of Appeals now has the opportunity, once and for all, to set a clear precedent on what the pari passu clause really means in sovereign debt contracts. This issue has been up in the air for far too long, unhappily for sovereigns. When Griesa gets his ruling overturned on appeal, we’ll finally have the pari passu ruling we’ve been waiting for since 2000. Of course, it’s conceivably possible that the appeals court will uphold Griesa’s ruling, and thereby deal a massive and pretty much unenforceable blow to sovereign debt management around the world. But it’s very unlikely. Elliott might have won the battle for its unorthodox pari passu interpretation. But in doing so, it’s set itself up for losing the war.

Update: I’m now told that despite litigating this suit for a decade, Elliott has chosen not to become a judgment creditor. Which may or may not be smart. In any case, bondholders have the right to accelerate their bonds — make all principal and interest due and payable immediately — if the pari passu clause is breached. But Elliott has already done that.

*Update 2: Elliott now confirms that it is a judgment creditor of Argentina after all. Right first time. Sorry about that.

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.

Ben Heller, a man who’s been trading CDS since before they were even called CDS, is out of the CDS market.

There have been rumblings about this market for a while: an FT article from March 9 quoted a series of unhappy people on both the buy side and the sell side.

One banker working on the Greek bond deal says: “I almost wanted CDS not to be triggered just so it would kill off the instrument and then we could set about designing something better to replace it.”

But with Heller going on the record about this, the pressure on ISDA to fix what is widely seen as a broken system is surely going to increase. Because he’s not alone.

“Many of the people you know from EMCA,” he tells me at the end of this video, “are people who are very focused on this issue and who are not going to let this one go.”

The world has long forgotten EMCA, an attempt by investors in emerging-market debt to team up and provide a united front in the face of attempted sovereign debt restructurings. But back when it was founded in 2000, it included all the biggest names in the emerging-market debt world, including Heller, who was then at HBK; Mark Siegel, at MassMutual; Abby McKenna, at Morgan Stanley Asset Management; Mark Dow, at MFS; and Mohamed El-Erian, at Pimco. The membership of Dow and El-Erian was particularly important, because they had both worked for many years in the official sector (Dow at Treasury, El-Erian at the IMF), and were taken seriously by policymakers.

EMCA never really got off the ground as an organization, partly because it turned out that policymakers, and their advisers, were more likely to pay attention to individual members than they were to respond seriously to carefully-honed collective statements. But clearly these people retain a certain amount of power: you can see that in the way that Greece’s new 2042 bond got quietly split up into 20 different bonds, each maturing in a different year.

Why did that happen? Because to a certain extent, the market is valuing Greece’s debt by working out how much money Greece is realistically likely to pay its bondholders over time, and then divvying up that value among the bonds outstanding. If some of the bonds have earlier maturities and some have later maturities, then more of the value will end up in the early-maturing debt, and less of it at the end of the yield curve. And so the value of the new 2042 bond is going to be lower, this way, than it would have been if it was the only bond being issued.

Why would creditors want a bond to trade lower? Because this way the 2042 bond becomes the cheapest-to-deliver bond when the CDS auction is held today, and the lower the price of the cheapest-to-deliver bond, the bigger the payout for anybody holding credit protection, including basis traders like Heller.

It seems to me that there were two opposing constituencies in the Greek default. One group, led by European policymakers, were very happy to see the CDS market get broken — they hate CDS, in exactly the same way that CEOs hate short sellers. The other group, led by fixed-income investors, wanted to make sure that the CDS market operated relatively smoothly and that the payouts were fair.

In the end, it seems, the buy-side won — but with the vivid realization that they had gotten lucky. Fixed-income traders never want to rely on luck and fortune when it comes to things as important as default protection. And so Heller, for one, is out of the market completely — unless and until ISDA does a root-and-branch revamp of its documentation. Which, if it happens at all, isn’t going to happen any time soon.

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.

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.