More Shadows Appear in the Greek CDS Fog

Econintersect:  A number of correspondents (see hat tips end of article) have pointed out several descriptions of the credit event that was declared Friday (March 09) by ISDA (International Swaps and Derivatives Association).  The announcement that a “Restructuring Credit Event” had occurred was reported and discussed by GEI News yesterday.  In that report the scheduling (by ISDA) of an auction on March 19 was one of the few well defined facts presented.  A number of other factors presented ended up with more questions than answers; therefore the term “factors” rather than “facts.”

Felix Salmon has reported that only some CDS contracts covered “restructuring events” and other CDS contracts will not be involved in the March 19 auction. Thus the question of why only €3.2 billion was the maximum CDS net for the event involving hundreds of billions in bonds is answered – few CDS contracts covered restructuring.

However, Felix, a skilled and knowledgeable financial reporter with excellent information sources, says this:

“…the whole CDS saga in Greece and elsewhere does rather feel as though ISDA is making it up as it goes along.”

It is apparent that only a small portion of CDS coverage for Greece contained the restructuring clause. Yet, The Wall Street Journal suggests today that:

“The real systemic danger would have come if lenders could have been forced to take 70% losses on Greek debt without their insurance kicking in. Sovereign debt would have become uninsurable.”

Adding Up the Numbers

The privately held Greek debt that was subjected to the “voluntary” haircut (totaling 70% in reduced principal plus reduced coupons and extended maturities) has been reported to be slightly in excess of €200 billion with a reduction in principal of €105 billion. According to the WSJ some €150 billion has come to be publically owned (ECB, EU, IMF etc.). This puts the total value of Greek sovereign debt at €350 +/-. With Greece GDP (World Fact Book) around $300 billion (approximately €225 billion), this puts the debt to GDP ratio about 160%, the generally accepted value.

After the private bond haircut the total debt becomes approximately €250 +/- and the debt to GDP ratio is about 110%. With Greek GDP falling like a rock under the burden of severe austerity, remaining under the maximum allowed ratio of 120% may be difficult. And, of course, Greece cannot run any significant budget deficit without going over the limit.

The success of the plan is predicated on Greece returning to GDP growth in 2013 but that has been viewed with skepticism by many. With GPD likely to fall in 2012 and 2013, according to many, there is doubt that the 120% limit is realistic.

So there seem to be some conclusions that can be drawn from the numbers:

• Private bond holders have lost $105 billion in principal plus future consideration (lower coupons, longer maturities).

• CDS may net pay up to $3.2 billion to compensate some of the loss (about 3%, but probably less, maybe only 2.3-2.4%).

• Greece is likely to fall “off the wagon” again in 2013, if not sooner. In such an event the losses for private bond holders may not be over.

If the future arrangements cannot be covered by a “restructuring” of debt, then a broader range of CDS contracts may come into play and a lot more than $3.2 billion net could be in play, subject to counterparty risk.

Conclusion

There have been a number of people who have suggested that the entire CDS scheme should be highly regulated, if not largely done away with. The conclusion of Felix Salmon’s column from March 9 suggests that such action may not be need:

“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.”

John Lounsbury

Sources:

• Greek CDS Wars (GEI News, 11 March 2012)

• Greece’s CDS: More Lucky Than Smart (Felix Salmon, Seeking Alpha, 09 March 2012)

Hat tips to ubetchaiam, Russell Huntley, Roger Erickson and Doug Clark.