March 11th, 2012
Econintersect: Credit default swaps (CDS) are agreements that one party will pay another party a specified amount if a default in a specified debt security or failure of a specific entity occurs. The party that buys a CDS is to be paid the contract amount by the party that sells (the counterparty) if a default or failure event occurs. For many contracts the arbiter of whether an event has occurred is ISDA (International Swaps and Derivatives Association). The ISDA formally declared on 09 March 2012 that a “Restructuring Credit Event” has occurred for Greek sovereign debt, bringing CDS obligations into play. The intent of the haircut process orchestrated by Greece and the EU to get bondholders of Greek government debt to accept about 30 cents on the dollar for the bonds they held, along with reduced coupon payments and extended maturities, was to avoid a credit event. That maneuver appears to have failed.
Follow up:The questions now are:
- Is all hell going to break loose?
- How much money is in play for Greek sovereign debt CDS?
- Will there be a counterparty risk panic as occurred with the collapse of Lehman Brothers in 2008?
- Is the contagion season starting where other sovereign debt risks and bank solvency issues suddenly get magnified?
The bottom line is that no one seems to be certain what happens next. But it also appears that the end of the world does not seem likely, at least not immediately, and all hell is not about to break loose (if your horizon is a week or so).
The next known event on the calendar is an auction to be conducted by ISDA to resolve the CDS arrangements that are brought into play by the announced event determination. This will occur on March 19. ISDA has announced that the net of CDS positions on Greek sovereign debt is about €3.2 billion. This means that after all contracts are netted some group of parties will owe some other group of parties that amount of money if all Greek debt value goes to zero.
But what is hidden under the netting out process could be some problems. For example, any bank that has not properly hedged its positions could be out much more than the total net amount. The nominal value of all CDS positions (before any netting) could be 10X larger (or even much more) than the €3.2 billion net. This net position for many participants could be a small amount, but a party making a big bet on the wrong side could be losing far more than the netted total loss offsetting a number of other players in the pool mostly making money.
An article by Alexandra Edinger of Dow Jones Newswires, appearing in The Wall Street Journal, has worked through the story for German Banks which are big holders of Greek bonds. She finds that they are all well hedged and there are no bombs waiting to go off there.
Whether some hedge fund will blow up for having bet the wrong way is not a matter of great systemic importance, unless they drag systemically important counterparties into a serious imbalance when it (the hedge fund) is unable to complete their side of CDS contracts. Whether this sort of troll lurks under the bridge remains to be seen.
ISDA has estimated that the total net exposure is likely to be less than the €3.2 billion identified as the auction unfolds to reach contract settlements. The reason being that the loss on the bonds will not be total and so the full settlement values will not obtain.
The small net value (€3.2 billion or less) implies that only the bonds outside the “voluntary” haircut pool are eligible for compensation, although Econintersect is still looking for clarification.
The total sovereign debt of Greece was over €200 billion and has been reduced by €105 billion. If the eventual coverage for the “voluntary” haircut is 95%, that infers a loss of about €5 billion +/- outside the “voluntary” pool. The CDS payout for that loss should be something close to the loss or less if settlement negotiations (auctions) arrive at a lower amount. So either the €3.2 billion figure represents the unusual situation that very little loss of €105 billion is actually covered or only the smaller amount outside the "voluntary" haircut pool is covered. Until there is more clarification, Econintersect will assume only the smaller amount of debt is covered by the event.
If this interpretation is correct, the entire CDS structure for Greek bond holders was of no value except for a very few. If the Econintersect interpretation is not correct then what value is there in a CDS arrangement that pays out €3.2 billion or less on a €105 billion loss? If this were insurance that payout is equal to what would be a 3% deductible on a reimbursable loss.
Editor’s note: What value does the CDS arrangement have other than creating transaction revenue for mediators, poker chips for finance speculation and accounting chits to conceal risk? These are fundamental issues. If there are no other points of value, then this process will have to be reclassified as a hoax and a fraud.
The following is the ISDA press release:
NEWS RELEASE For Immediate Release
ISDA EMEA Determinations Committee:
Restructuring Credit Event Has Occurred with Respect to
The Hellenic Republic
LONDON, March 9, 2012 – 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 EMEA DC resolved that a Restructuring Credit Event has occurred under Section 4.7(a) of the ISDA 2003 Credit Derivatives Definitions (as amended by the July 2009 Supplement) following the exercise by The Hellenic Republic of collective action clauses to amend the terms of Greek law governed bonds issued by The Hellenic Republic such that the right of all holders of the Affected Bonds to receive payments has been reduced.
The Committee determined that an auction will be held in respect of outstanding CDS transactions on March 19. ISDA has published a list of obligations issued or guaranteed by The Hellenic Republic, which the EMEA Determinations Committee is currently in the process of reviewing. That list can be accessed here: http://www2.isda.org/preliminary-greek-obligations/.
ISDA will publish further information regarding the potential auction on its website, www.isda.org/credit, in due course.
Answers to frequently asked questions regarding The Hellenic Republic Restructuring Credit Event can be accessed via ISDA’s Greek Sovereign CDS page: http://www2.isda.org/greek-sovereign-cds/
ISDA will host a press briefing today at 9PM GMT / 4PM EST addressing the credit event ruling. A live webcast of the briefing will be available at: http://services.choruscall.com/links/isda120309.html.
- Greek Sovereign CDS (ISDA Web Site, 09 March 2012)
- ISDA Press Briefing (Conference Call webcast audio, 09 March 2012)
- Preliminary Greek Deliverable Obligations/ (ISDA website, 07 March 2012)
- German Banks: Small Impact Seen From Greek Credit Event, CDS Triggers (The Wall Street Journal, Alexandra Edinger, Dow Jones Newswires, 09 March 2012)
- Greece turns to growth, elections after debt deal (Harry Papachristou, Reuters, 10 March 2012)