Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 6 March 2012

Greece: CDS is the pawn in a game of chess


The Eurozone crisis is running along predictable lines. Unsurprisingly, Venizelos has revealed that the “voluntary” Greek debt swap is actually an offer that cannot be refused. This was after a pathetic grand total of 12 institutions signed up for the IIF’s complicated loss-taking exercise. According to the IIF these holdings represent a “substantial” part of the €206bn of private sector holdings. If that is indeed the case, all these institutions should fire their risk manager/trader without delay. It would probably boost their enterprise value more than any convoluted swap agreement.

The amazing and unexpected part of the Greek debt swap saga is that Greek pension funds, the civil service union and some Greek banks are resisting signing on the dotted line according to the FT. The pension funds claim the Greek central bank invested their cash reserves in bonds without consulting them. Talk about chutzpah.

Given the situation, it seems like CACs will be used to force losses thus triggering CDS. So the critics can rest easy, CDS is not worthless (yet). This whole fuss about ‘why isn’t CDS triggering’ was slightly perplexing. No less a man as Bill Gross voiced this question even as his firm voted that there was no credit event. The reason for the non-trigger is simple: No losses have been imposed (it has been all “voluntary” so far remember). Also, insertion of a CAC by itself is not a credit event. It is the use which binds all holders which constitutes a credit event. Just because someone has a gun and threatens to use it does not mean they are guilty of murder yet.

The event that will determine the fate of sovereign CDS is the auction settlement after the inevitable trigger. The fear is that all old Greek bonds are swapped for new ones which trade close to par. This would imply that CDS buyers lose a mammoth 70 points ($7m per $10m notional) from their marks. It may lead to defenestration of traders left holding basis packages. Moreover, it would call into question the entire sovereign CDS market as the market realises EU’s desire to punish the evil CDS speculators. Of course, sovereign bonds will become unhedgable. But the main buyers are now domestic banks and asset managers tied to the mast of index benchmarks. The former have just taken out 1trn of fresh money from the ECB to play the carry trade and the latter just care about losing less than the index.

It is possible that Greece leaves a few bonds unswapped to enable auction settlement at the fair impaired price so that hedges retain value. This was done in the case of Anglo-Irish where the Irish government intelligently decided that CDS was not the enemy. Unfortunately political stakes are higher now and intelligence commensurately lower.

However, there is a way out from the EU’s derivative killing fields and ISDA is likely to take it. There is going to be a period of time between the activation of the CACs and the exchange of old bonds for new. If the auction occurs in between these two events then the auction settlement price will be the price of the impaired Greek-law bonds. CDS gains would mirror bond losses preserving the hedge and more importantly the relevance of CDS. ISDA may be conflicted but it is not suicidal.

Of course, EU can ban trading and ownership transfer of Greek bonds post CAC activation. That would be check mate.

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