Tuesday, February 21, 2012

The market is now pricing in Greek sovereign CDS trigger

A curious thing happened with the Greek sovereign CDS in the last couple of days. It widened out in spite of the bailout agreement. The chart below shows "points upfront" for the Greek 5-year CDS in the past few weeks. (Note that the "spread" widened also, but for such a distressed credit, spread is not meaningful as transactions are all done based on "points upfront" - see this post for some background on the topic.) As of the afternoon of the 21st, the mid-price was around 73 - considerably higher than in the days leading up to the agreement.

5-year Greek sovereign CDS points upfront

Typically a widening in CDS represents a deterioration in the credit and would correspond to a selloff in the bonds. But as the next chart shows, Greek bonds have not reacted much to the bailout deal. The bonds "maturing" in 2034 have been trading at about 25c on the euro in the past couple weeks - with no significant downward movements. In fact some of the other bonds actually bounced slightly.

Greek 5.2-7/34 government bond prices (Bloomberg)

So how is it possible for the CDS to widen (increase in price), while bonds of the same credit are stable? Something is making the CDS more valuable but not impacting the credit's performance. The answer is that the market is now pricing in a CDS trigger. As the CDS is more likely to have a credit event (trigger), it becomes more valuable. And that is why we are seeing an increase in the CDS price in the last couple of days.

Analysts are now becoming more convinced that the voluntary exchange/haircut isn't going to get the participants necessary to reach the debt-to-GDP targets that have been agreed to as part of the package. Roughly 75% of the bond holdings would need to be exchanged for this to work. If there aren't enough participants, Greece will be forced to go the route of collective action clauses (CAC). It will need to push through a parliamentary procedure to retroactively include CAC into the existing bonds (outside of those held by the ECB) in order for the majority to be able to force the holdouts to take the haircut. If that happens, Greece will get to their required debt/GDP target and receive their bailout.

But this action, no longer being "voluntary", will be a credit event for the Greek sovereign CDS. Once that happens, there would be an auction for eligible Greek bonds that will determine the recovery level (the payout is equal to par minus the recovery level) for the CDS. If bonds trade at 25, the CDS should trade at 75 if there was a 100% chance of trigger. Since the CDS now trades at 73, it is pricing in a decent probability of this credit event. There is only about 2-3bn of net Greek CDS that would need to be settled. As discussed before, this will generally be a non-event, since any P&L has already been taken by the participants.

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