Greece is defaulting on its loans.
OK, technically, that’s not true.
The official version is that Greece’s creditors have agreed to a “voluntary” haircut of 50 percent on the outstanding debt. The word voluntary is key. Because the haircut is technically voluntary, a credit event will not be triggered, which means everyone who bought credit default swaps (CDS) on Greek debt will not receive the insurance payout they expected when buying the contract.
It’s akin to crashing your car and the insurance company telling you “sorry, you didn’t crash your car just right so we won’t pay.”
This sets quite a precedent. The financial markets now assume that if a developed market economy is unable to pay its debts, rather than default a structured settlement of sorts will be crafted, which as stated above, will not trigger CDS payments.
That being the case, investment-grade sovereign CDS seem on the surface a bit useless. Why buy credit protection if it won’t pay out when you need it to? That question has led many in the industry to claim that sovereign CDS are now on their death bed.
I disagree. If anyone will kill sovereign CDS, it will be central clearing mandates, not Greece.
How will this play out?
First, legal action is inevitable. Credit protection buyers will sue credit protection sellers. Credit protection sellers – mostly big global banks – will sue someone and everyone in the government related to the agreement. And it goes without saying that industry groups will lobby the European Commission to make changes to the settlement. The interesting twist here is that the agreed-upon solution to the debt crisis is good for the market as a whole, so fighting the terms of the deal to fix the CDS problem is wrought with a conflict of interest.
If Greece were allowed to default, triggering CDS payments, it seems inevitable that at least a few CDS protection sellers would face bankruptcy themselves. That being the case, payment on the triggered CDS would be in question anyway. So whichever way you slice it, a prolonged legal battle is inevitable.
This battle will lead to a restructuring of the terms for sovereign CDS going forward – more of a rebirth than a death. Just as the U.S. government wrote Dodd-Frank in part to “prevent the next AIG,” ISDA, who governs CDS contract standards, will rewrite the terms of the standard agreement to prevent the next Greece. But that still leaves existing CDS holders in bad shape, right? Not necessarily.
Derivative contracts with optionality are often bought by investors with no intention of taking delivery of the underlying asset. Equity options, for example, can be used to speculate on volatility and are often sold before expiry without being exercised. Futures contracts can be used to speculate on the price of just about anything and are often sold before the delivery date. CDS contracts are no different.
According to MarkIt, the spread on Greek CDS in January 2011 was around 1,000 basis points; in late September it went over 4,000. Do I have to spell it out? That means if you bought in January and sold in September, you made a 400 percent return. Not such a bad investment, if you ask me. I also suspect that a substantial portion of those buying up Greek CDS in 2011 never expected a payout and were instead placing bets on the probability of default as shown above.
It has been well known for many months that a solution to the Greek debt crisis might not trigger a credit event, so savvy credit market participants had plenty of time to adjust their holdings and place bets based on this information. And the fact that Greek CDS spreads tightened after the deal was announced shows the market is responding exactly how one would expect – lower default probability, lower cost of buying protection. Does that sound like a dead contract to you?
One monkey wrench in that last scenario is the EU ban on naked CDS. It will be much harder to take such speculative bets if you also must hold the underlying bond. However, I foresee numerous ways around that. No such ban exists in the U.S., at least not yet. It also seems likely that a new repo-like structure will be created to temporarily place the needed bonds with the holder of the CDS for a small fee. That fee will of course impact the profitability of such strategies, but not to such an extent that they will become uneconomical. In the meantime, we can expect to see proxy strategies emerge such as the shorting of national bank stocks in place of shorting the sovereign CDS.
If there’s a good reason for low confidence, speculators will find a way to profit from it.
As one commentator in TABB Group’s soon-to-be-published research on European swap dealers put it, “Trying to contain the Eurozone crisis with CDS short-selling bans is like using concealer to mask welts caused by bubonic plague. You are just masking the symptoms; you are not doing anything to cure the underlying issues.”
That takes us to central clearing.
OTC derivative clearing mandates are going to see the light of day before the end of 2012. As some of the most heavily-traded CDS contracts, sovereign CDS seem likely to fall under these clearing mandates. The Greek situation however highlights the problem with moving sovereign CDS into a cleared environment.
I think my recent quote in Bloomberg News says it best: “Look at Greece possibly defaulting, it’s causing a global disaster. Can you imagine if Germany defaulted? A clearinghouse wouldn’t do any good. There’d be a knock-on effect to every systemically important institution in the world.”
Taking that into account, the only way clearinghouses could clear sovereign CDS would be to set huge margin requirements – potentially 50 percent or higher. That would make it uneconomical to use the instrument for most strategies, essentially killing the contract as we know it today. One of the reasons CDS came into being in the 1990s was to create a cheaper method of shorting the bond.
In the aforementioned scenario, shorting the bond might very well come back in vogue. The other potential end-games include sovereign credit futures or a new structure that does not fall under the CFTC’s definition of swap. It’s important to keep in mind that the financial markets need to manage exposure to sovereign debt (obviously), so structures that provide credit protection cannot completely disappear.
This story is far from over.
ISDA still must make its official ruling on whether a credit event occurred and that could take weeks if not months.
But regardless of how they decide, it’s more likely that Dodd and Frank will kill the sovereign CDS market than Greece.