Default Semantics

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city because of his health, for the waters. Informed that they are in the desert, Rick replies, with an ironic tone, that he has been ”misinformed”. Investors and banks that purchased Greek sovereign credit default swaps (CDS) to protect themselves against the risk of the country’s default may find that they have been similarly “misinformed”.

As part of the “grand plan” to resolve Europe’s ongoing debt crisis, the Institute of International Finance (IIF), a global trade body representing bankers, voluntarily accepted a 50 percent “haircut” on its holdings of Greek bonds. The associated linguistic gymnastics, with default redefined as “restructuring”, and the structure of any final deal on Greek debt, have implications for the arcane workings of the CDS market. While the net outstanding volume of Greek sovereign CDS is modest at around US$3.7 billion, the current imbroglio raises important questions about the role and efficacy of CDS contracts generally.

Details of the negotiations published by Bloomberg highlighted the voluntary nature of the arrangements. Europe’s leaders summoned bankers at midnight to Luxembourg Prime Minister Jean-Claude Juncker’s office, presenting Charles Dallara, managing director of the IIF, with an ultimatum: take a package involving a 50 percent writedown of Greek debt or face worse consequences, namely the total insolvency of Greece. Bankers had little choice under the circumstances, though whether the EU would really have been willing to allow the total insolvency of Greece, resulting in the failure of some banks and large claims on the public purse to recapitalise them, will be long debated.

Similar to credit insurance, in a CDS, the buyer of protection pays a fee to obtain indemnification against the risk of default of a borrower (Greece) and any resultant loss from a protection seller. Payment is triggered by a “credit event”, technically defined as a failure to pay interest or principal, a debt moratorium or repudiation, or “restructuring”.

“Restructuring” involves a material restructuring of an entity’s payment obligations or a forced substitution of new obligations. Generally restructuring will entail any of the following:

  1. Changes in the ranking of the debt, reducing seniority, subordinating the obligation or converting debt into equity;
  2. A change in the currency of payment (other than into certain permitted currencies—for example, currencies of G-7 countries or OECD members with a local currency long-term debt rating of either AA or higher);
  3. Any reduction in the interest or principal payable; and/or
  4. Deferral or postponement in the date of payment of any interest or principal.

Restructuring is not considered to have occurred where it is not directly or indirectly related to deterioration in the creditworthiness or financial condition of the entity.

Voluntary restructuring—entailing lenders agreeing to an exchange by Greece of existing bonds and loans for ones with different terms (longer maturity, different rates)—may not constitute a credit event under the CDS. This is because lenders would be agreeing “voluntarily” to subscribe to new debt which would be used to pay off existing or maturing debt. The original debt is not “restructured” in legal terms. This means that, for Greece, only a “hard” default—a failure to pay, full debt rescheduling or non-voluntary or forced exchange—would allow the CDS protection buyer to trigger the contract.

The final arbiter of whether the Greek CDS has been triggered will be the Determinations Committee (DC) of the industry association and rule-setter for the derivatives market, the International Swaps and Derivatives Association (ISDA). The DC comprises 10 bankers and five investors. Unless backed by a supermajority of 12 out of 15 members, its decisions are externally reviewed by a committee of “independent experts”. While perfectly legal, the ability of a private body of financiers and lawyers to determine whether or not there has been “default” is unusual and legally untested.

In contrast, the rating agencies have indicated that any such voluntary exchange will be regarded as “selective or restrictive default”.

Where a CDS contract was purchased to hedge existing holdings of bonds or loans, an inability to trigger the contract will mean that investors will not be compensated for any losses on such holdings. Depending upon the terms of the exchange, the new bonds may trade at prices below par (based on the experience of previous, similar exchanges) reflecting differences between the return demanded by markets relative to the new bond’s economic terms. This will result in investors incurring losses.

Where the CDS was entered into as a pure “bet” on the likelihood of a Greek default, the speculators taking the other side of the bet (on there being no “default”) will prevail, despite the economic reality of Greece’s “restructuring”.

All participants who purchased protection will also have incurred the cost of hedging for the ineffective CDS contracts.

So, for banks and investors who entered into CDS contracts to insure against losses from a Greek default, the potential failure calls into question the entire economic effectiveness of credit derivatives. The technical nature of the arrangements also highlights the potential legal issues present in CDS contracts. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract, complicating significantly the effects of the contract and its efficacy as a hedge.

As regulators and accountants assumed that the CDS eliminated or minimised any risk of losses, the level of capital and reserves set against the risks of Greek investment may turn out to be incorrect, while the accuracy of financial statements is also in doubt.

The question now is whether similar arrangements will be used if any other sovereign entity finds itself, like Greece, in serious financial distress. In effect, the value of CDS contracts is questionable. This means that risk models and hedges will need to be amended.

Following the announcement of Greece’s voluntary restructuring, many traders, both hedgers and speculators, liquidated CDS positions. In part, this reflected traders swapping CDS for short bond positions, which would have gained on the voluntary writedowns. The five year Greek CDS spread fell by more than 20 percent to close at 34.36 percent.

Ultimately, these problems raise a vital fundamental question: are CDS and, more broadly, derivatives, useful and legitimate instruments of risk transfer?

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