Greek Bailout Kills the Sovereign CDS Market?

Abigail Moses of Bloomberg reports, Greece Default SWAPS Don’t Have to Pay:

Default insurance on Greek debt won’t be paid out, the International Swaps & Derivatives Association said after it was asked to rule whether part of the nation’s $170 billion bailout was a credit event.

The group said the European Central Bank’s exchange of Greek bonds for new securities exempt from losses being imposed on private investors hasn’t triggered $3.25 billion of outstanding credit-default swaps. ISDA’s determinations committee, including JPMorgan Chase & Co. and Pacific Investment Management Co., said the switch didn’t constitute subordination, one of the criteria for a payout under a restructuring event.

“The situation in the Hellenic Republic is still evolving” and today’s decisions “do not affect the right or ability to submit further questions,” ISDA said in a statement. The decision is not an expression of the committee’s “view as to whether a credit event could occur at a later date,” the association said.

A swaps payout may still happen if Greece uses collective action clauses on private investors who refuse to take so-called haircuts on their debt holdings, according to ISDA’s rules. Officials including former ECB President Jean-Claude Trichet have opposed triggering swaps because they’re concerned traders would be encouraged to bet against failing nations and worsen Europe’s debt crisis.

‘Big Issue’

“There’s value to getting some clarity even if the ruling’s no,” said Peter Tchir, founder of New York-based hedge fund TF Market Advisors. “It’s a pretty big issue for what they’re trying to do in other countries.”

It costs $7.3 million in advance and $100,000 annually to insure $10 million of Greek debt for five years, signaling a 95 percent probability of default within that time. Greek 10-year bonds slumped to a record 19.14 cents on the euro after the ruling.

Political determination to avoid the stigma of a credit event has been waning as Greece struggles to meet the conditions of its latest 130 billion-euro ($170 billion) bailout. Standard & Poor’s downgraded the nation to “selective default” on Feb. 27 because of the government’s decision to retroactively insert CACs into bond terms.

While Greece is negotiating the biggest ever debt restructuring, the volume of credit-default swaps on the line has tumbled. The net amount of debt protected is no more than for some companies and represents less than one percent of the nation’s bonds and loans outstanding.

Credit-default swaps on Greece now cover $3.25 billion of debt, down from about $6 billion last year, according to the Depository Trust & Clearing Corp. That compares with a swaps settlement of $5.2 billion on Lehman Brothers Holdings Inc. in 2008.

Counterparty Concern

Despite concerns at that time about a daisy chain of losses if counterparties failed to meet their commitments, the Lehman settlement and those of swaps guaranteeing debt of Fannie Mae and Freddie Mac were “orderly” and caused no major disruptions for the market, according to regulators.

A settlement on Greek swaps may bolster confidence in the $258 billion sovereign insurance market and also help boost the government bond market, Tchir said. Efforts to circumvent a trigger risk undermining credit markets.

“The relevance of sovereign CDS has been called into question, but they still have value,” said Georg Grodzki, head of credit research at Legal & General Plc in London.

Insurance payouts may still happen if Greece uses the collective action clauses its parliament introduced or if it fails to make a payment in future. If an event is declared, auctions will be held to set a recovery value on the bonds, and swaps sellers will pay buyers the difference between that and the face value of the debt.

Failure to Pay

Swaps on western European governments can pay out on a credit event triggered by failure to pay, restructuring or a moratorium on payments. Restructuring events are the most subjective and have been removed as a trigger event for U.S. companies.

A restructuring event can be caused by a reduction in principal or interest, postponement or deferral of payments or a change in the ranking or currency of obligations, according to ISDA rules. Any of these changes must result from deterioration in creditworthiness, apply to multiple investors and be binding on all holders.

The determinations committee that decides whether to trigger swaps consists of representatives from 15 dealers and investors. The group rules whether a credit event should be declared after a request is made by a market participant. The question on Greece was posed anonymously.

‘Pain to Come’

“Technically the issue of the ECB subordinating other investors hasn’t yet inflicted pain -- just the threat of pain to come,” said Bill Blain, a strategist at Newedge Group in London.

A request on Irish swaps was rejected last year when ISDA’s determinations committee ruled the International Monetary Fund’s preferential creditor status in that nation’s rescue didn’t constitute subordination.

“Restructuring almost always causes confusion,” Tchir said. “The fact that it is a restructuring does leave it lot more subjective than it would be otherwise.”

This is what I predicted. They weren't going to trigger CDS contracts and wreak havoc on financial markets.

Is this a good thing? Depends who you ask. Felix Salmon wrote a comment on how Greece’s default could kill the sovereign CDS market, noting the following:

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.

Sounds like Felix Salmon is an apologetic for hedge funds if he's claiming that sovereign CDS, 'when they work', are a useful thing. The truth is that some hedge funds speculated like crazy on Greek bonds and got burned on CDS. Tough luck, don't shed a tear for them and if this kills the sovereign CDS market (doubt it), then so be it.

I know, CDS traders will protest, warning me that killing the sovereign CDS market will increase interest rates in the periphery because investors won't be able to protect themselves adequately, thus to attract them, governments will have to increase yields on their bond offerings.

I am skeptical of all these dire warnings. The amount of speculative abuse going on in the sovereign CDS market -- as opposed to plain hedging activity -- has wreaked havoc on periphery economies. It's high time policymakers put an end to this nonsense. ISDA's ruling also means counterparty risk won't explode, which is bullish for risk assets in the near term.

Below, default insurance on Greek debt won’t be paid out, the International Swaps & Derivatives Association said after it was asked to rule whether part of the nation’s $170 billion bailout was a credit event. The group said the European Central Bank’s exchange of Greek bonds for new securities exempt from losses being imposed on private investors hasn’t triggered $3.25 billion of outstanding credit-default swaps. Michael McKee and Erik Schatzker report on Bloomberg Television's "InsideTrack."