Friday, 24 February 2012

Greek Sovereign CDS

One minor but interesting aspect of the latest Greek bail-out is its effect on Greek government CDS.  When the private-sector write-down was first agreed back in October, it was accepted that it would be voluntary and so would not trigger CDS payouts.  This time, I'm fairly sure that there will be a triggering event, despite the scepticism of some commentators.

There are two reasons why I think so.  First, the Greek government says that it will today introduce legislation to parliament retrospectively to apply "collective-action clauses" for most of its debt (the part governed by Greek law).  This will be necessary to force the quite large minority of its debt-holders which is not susceptible to international government arm-twisting to accept the write-down.  And ISDA, the body responsible for ruling on defaults for CDS purposes, made an unambiguous statement last month about this possibility:
...the inclusion of a CAC would not, in and of itself, be expected to trigger a Credit Event. On the other hand, the use of such a clause to effect a reduction in coupon or principal or one of the other events set out in the definition of the Restructuring Credit Event could trigger if the other requirements of the Restructuring Credit Event were met (for example decline in creditworthiness), as its effect would be to bind all holders of the relevant debt.
Which is to say that if the CAC is implemented and then used to force a write-down, ISDA will declare that CDS payouts have been triggered.  European politicians will be asking them not to, because they've been straining throughout the crisis to avoid anything that could be called a default.  And some American banks and insurers will be doing the same, because they've written the CDS contracts.  But ISDA has stated its position, which is mandated by its own procedures.  Its argument last time round was that a voluntary write-down is not a "restructuring credit event", whereas a write-down that "binds all holders of the 'restructured debt'" would be.  There's no getting out of that logic.

Second, the markets think it's going to happen.  Markets tend to get these things right, because there's a lot of money being staked on the analysis.

How much does this matter?  Well, it would restore some meaning to the sovereign CDS market.  But the direct financial consequences are quite small.  Because every CDS has its own expiry date and swap rate*, if you want to trade out of a CDS position you have to enter into a new contract that roughly offsets the risk.  Net positions are therefore much smaller than gross positions: Table 6 here shows gross notional $69.9bn, net notional $3.2bn (in the "Hellenic Republic" row).  There's a plot here showing the net positions of individual banks: if you're a British taxpayer, and hence have a financial interest in the fortunes of RBS, you'd like the CDS to pay off.

*Exchange-trading of CDS using standardized contracts was introduced in 2009.  But these contracts don't yet dominate the open interest.

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