Trash heap for sovereign CDS?

October 27, 2011

For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies. In short, the agreement reached in Brussels last night outlined a haircut on Greek government bonds of some 50 percent as a way to keep the country’s debt mountain sustainable over time. But anyone who had bought default insurance on the debt in the form of CDS would not get compensated as long as the “restructuring” was voluntary, or so says a top lawyer for the International Swaps and Derivatives Association — the arbiter of CDS contracts.

ISDA general counsel  David Geen said there would be no change in the ruling to account for the size of the haircut:

As far we can see it’s still a voluntary arrangement and therefore we are in the same position as we were with the 21 percent when that was agreed (in July)

Putting that in a bit more perspective, the International Monetary Fund’s Olivier Blanchard said in Dublin later on Thursday that the Greek deal could raise serious questions about the value of CDS as a hedging tool:

The general position is that if you are able to reduce the claims of creditors by a substantial amount without triggering a CDS event… that raises questions about the value of the CDS

If it’s true that CDS contracts on euro sovereign debts are effectively worthless to the extent that European governments can pressure their banks into accepting “voluntary” debt workouts, then that would mark a significant victory for politicians who have long argued that CDS speculation — especially by those not holding the underlying debt — was a major aggravator of the euro zone debt crisis. It’s worth remembering the words of IMF chief, then French finance minister,¬† Christine Lagarde –who early last year questioned the “validity, solidity of CDSs on sovereign risks”.

The main charge against CDS is that it scared the horses excessively by creating panic among real creditors about default probabilities — becoming a self-fulfilling prophecy as debt refinancing suddenly became prohibitively expensive even though fiscal adjustment would always takes some time. There were also a concerns about potential conflicts of interest. Bans on “naked” CDS speculation were discussed and a whole “cat or canary” debate smouldered for the past two years. One of the biggest concerns among European officials was that triggering a “credit event” in CDS would reward this adverse speculation and fuel both direct financial and psychological contagion to other sovereigns. As a result, they set about ensuring the contractual bodyswerve that has subsequently satisfied ISDA.

However, Citigroup’s chief economist Willem Buiter argued this week that the implications of not triggering CDS payouts in a deep Greek debt restructuring could be more damaging than allowing a credit event that sees CDS work as planned.

Buiter argues that, unlike the chaos of the Lehman Brothers implosion, CDS on Greek debt is relatively limited and fairly transparent to both the authorities and other financial players and therefore a payout could reasonably be more contained. But sidestepping contracts could have a more detrimental effect by deterring potential sovereign creditors who would subsequently fear the lack of a hedging tool and also by undermining credibility in European governments to honour private contracts.

What is more, avoiding a CDS trigger when the fundamentals suggest otherwise would further erode credibility of EU/EA policymakers. Such an erosion of policymaker credibility would be especially problematic currently, as the
Euro Area support facilities, including the original EFSF, and even more so the
currently discussed future reincarnation of it, rely on the credibility of the promise that guarantees by EU/EA sovereigns will be honored. Any action that undermines the credibility of that promise has the potential to unravel the entire support architecture, a risk surely not worth taking if the alternative is the likely very manageable effects that CDS triggers might have.

That’s quite a defence, even if many may argue that sell-side global bank like Citi would of course defend the smooth operation of credit markets in which it operates. But it supposes the only problem with sovereign CDS is in the euro zone. Contractual CDS issues and debates over “credit event” definitions have been a factors in emerging markets for years.

But to the extent that CDS on developed country sovereigns has only been around since 2006, some commentators reckon the Greek manoeuvre may consign that particular version of credit insurance to the historical dustbin of failed financial “innovations”¬† — alongside such notables as “Perpetual Floating Rate Notes, Libor-cubed Notes, Asset Backed Collateralised Debt Obligations, War Loans, Endowment Mortgages”




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The consensus is that a 50% haircut on Greek debt, short of triggering a credit event, will do more harm than good. Regulators are yet again undermining CDSs, the very instruments put in place to hedge against corporate and sovereign risk, leaving market participants questioning whether the focus was really on stabilizing the Euro Zone economy or it was a way to avoid a Lehman-style collapse of the Hellenic Republic of Greece.

From my perspective a Greek default would actually benefit the Euro Zone. This would provide a shot across the bow to Portugal, Spain or Italy to get their economies in order expeditiously, bringing more stability to the EU. The lynchpin to market stability is accurate, real-time pricing data. For example this afternoon, Greek CDSs were trading erratically with most showing a sharp tightening of their five-year spreads to around 54% upfront or 3,600 bps. This is a time when pricing data is vital. Without this information, customers have no visibility into the CDS market, inhibiting their ability to utilize this instrument to effectively hedge.

Ultimately we won’t know until sometime in 2012 how this will all play out. However, we do know we’re on the precipice of some market changing decisions within the CDS community as to whether these instruments can be used as an effective hedging tool moving forward.

–Jonathan Epstein, head of credit derivatives, SuperDerivatives

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