IMF: Evidence does not support the ban on naked SCDS purchases

As discussed back in September (see post), the hysteria over sovereign CDS (SCDS) within the European Commission and other governing organizations has been completely overblown. Sovereign CDS has been more of a "canary in a coal mine", while EU politicians, bureaucrats, and often the public would sometimes prefer that the world does not know that their "sovereign canary" has died.

The IMF recently came out with a report confirming that much of the regulatory madness governing SCDS within the EU is unproductive. And a big part of the regulatory effort has in fact focused on the wrong risks.

IMF: - ... the evidence here does not support the need to ban purchases of naked SCDS protection. Such bans may reduce SCDS market liquidity to the point where these instruments are less effective as hedges and less useful as indicators of market-implied credit risk. In fact, in the wake of the European ban, SCDS market liquidity already seems to be tailing off , although the effects of the ban are hard to distinguish from the influence of other events that have reduced perceived sovereign credit risk. In any case, concerns about spillovers and contagion effects from SCDS markets could be more effectively dealt with by mitigating any detrimental outcomes from the underlying interlinkages and opaque information. Hence, efforts to lower risks in the over-the-counter derivatives market, such as mandating better disclosure, encouraging central clearing, and requiring the posting of appropriate collateral, would likely alleviate most SCDS concerns.

As much as we all were fascinated by the Greek CDS settlement, in the bigger scheme of things it was a non-event (see post). Once again it's worth pointing out that CDS is not insurance and operates more like a futures contract with margin calls taking place long before there is an event.

Also it's important to note that with all the fears of systemic risks, sovereign CDS represents only around 1% of the daily trading volume of the credit default swaps market - which is completely dominated by corporate CDS.

 Source: DTCC Deriv/SERV

Moreover, most of this trading volume is in the various index CDS such as iTraxx and CDX. And those products are not materially different from index futures which we all know and love. So for those who like to pontificate on the evils of the sovereign credit default swaps markets (and this includes the European Commission), please get your facts straight.

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The Greek CDS auction is a non-event

Well it's done. The "scary" Greek CDS auction is over.

Bloomberg:  Sellers of credit-default swaps on Greece will have to pay as much as $2.5 billion to settle contracts triggered by the nation’s debt restructuring.

The settlement was determined after dealers agreed a final value for Greek bonds of 21.5 percent of face value at an auction, according to administrators Markit Group Ltd. and Creditex Group Inc., and is in line with where the notes have been trading.

Yes, the $2.5 billion number represents the Par less Recovery amount on the $3.2 bn net CDS outstanding. As predicted, it's a non-event, particularly given the number of participants involved. Some corporate defaults have resulted in far larger CDS settlements - and nobody died. The recovery lock sellers got hurt a bit. Locks were traded at 24 a few days back and will now settle against 21.5. But that's the nature of the beast.

Source: The Telegraph

This is not the first sovereign CDS settlement and certainly won't be the last, as we start looking forward to other candidates such as Ukraine, Hungary, etc. And it is quite likely that Greece will be back to "break the chains of debt" (again) for a CDS settlement redux.

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Recovery lock on Greece is pricing final haircut at 76%

Dealers are seeing brisk trading in Greece recovery locks. As discussed before a recovery lock is a derivative contract that allows one to bet on the outcome of a CDS auction. Given the uncertainty around which bonds may end up being delivered to the Greek CDS auction, some are using these trades to take out their recovery risk. Yesterday the lock was trading at 24 (24 cents on the euro recovery). That means the market is pricing the final haircut at 76% - which is what the CDS is expected to pay out.

Source: Barclays Capital

For a good overview of recovery lock swaps, see the attached presentation.

Recovery lock

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The latest on the Greek saga

As predicted, the PSI results have triggered a Credit Event. Greece is officially in default. Again, the reason for the big fuss (with some in the financial media completely confused) about the 85% vs. 95% yesterday is that 85% would have resulted in CACs while 95% would not have. That's because 95% would have given Greece enough of a debt reduction without the need for CAC.

The actual number ended up being 83.7% participation for all Greek bonds, 85.8% for Greek Law bonds and 69% for Foreign Law bonds. Here are the results.

Source: BNP Paribas

This afternoon the equity markets reacted negatively to the ISDA announcement that a Credit Event has indeed been triggered. Market's reaction is a bit surprising, given the trigger was fully expected. Some traders are still scared of the old Greek CDS bogeyman.

So what will happen to the holdouts? The 25bn of bonds under the Greek Law will be "CAC'ed" as the chart above shows. They will be forced to deliver their bonds in exchange for the shiny new Greek bonds. The 9bn holdouts of Foreign Law bonds will be looking for door # 4. Some will get "CAC'ed". Others will be able to form blocking positions (each bond will be treated separately).

In the case of a relatively small amount of Greek government guaranteed railway bonds (about 400 million euros issued by Hellenic Railways) there is a chance that bond holders will get paid more than what they would get via the PSI exchange. Here is a good write-up on why that is.

The other holdouts are taking a big chance, although they still have some time (Greece is extending the deadline for Foreign Law bonds tender until  March 23d.) Trying to take on Greece in a UK or a Swiss court is very risky and likely to backfire. Getting a 53.5% of face value haircut is better than getting 100% haircut - plus massive legal bills and years in court (as some have found out the hard way with Argentina). It's not a good idea for the simple reason that Greece simply doesn't have the money to pay them and is unlikely to do so (as it clearly stated again on Friday).

Greece will have a tough enough time just making the ECB whole. The ECB is holding Greek bonds with relatively short maturities (€4.6bn maturing this month alone) and is expecting to be paid par. With the ECB's seniority, Greece will have no money left (see the IFR article on the topic) to pay the holdouts. As the saying goes, "you can't squeeze blood from a stone". The sad fact remains however that unlike many corporate restructurings which are meant to turn the company around, the situation with Greece is grim even after the debt reduction.

IFR: ...one sovereign restructuring adviser said that the situation remained unattractive for bondholders since Greece would remain in such a tough economic position with a heavy debt burden even after the deal cuts out €100bn of liabilities.

“Normally, people tender into an improving situation because they see the debt burden will be reduced and the economy will recover,” he said. “But with Greece it’s very depressing. People tendering here have no option. And I can’t see a significant upside soon.”

And unlike Argentina who has natural resources and was able to rebuild its economy after the default plus a restructuring (although still has major issues), the future for Greece is quite bleak. The likelihood of another default (this time on the new, post-PSI bonds) and an eventual exit from the Eurozone remains high.

Greek unemployment rate (Bloomberg)

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There is no door # 4 for the Foreign Law Greek bond holders

Here is some friendly investment advice for those holding a portion of the €18 bn of the “Foreign Law” Greek bonds. You have 3 "doors" to exit your position.

Door #1: If you can still sell your bonds at a premium to the “Greek Law” bonds, that's your best option, but you should sell soon. That premium will be going away shortly and you will have no choice but to participate in the PSI exchange or deliver your bonds to the CDS auction.

Door # 2: If you don’t sell your bonds now, you may have to exchange them in the PSI. In which case your premium to the Greek Law bonds is gone.

Door # 3: When Greece enforces the Collective Action Clause, which they have recently installed into their bonds, the CDS Event of Default will be triggered (subject to ISDA Determinations Committee decision). Your last exit will be to deliver these bonds into the CDS auction.

Many Foreign Law Greek bond investors are holding out for Door #4, in hopes of creating a “blocking position” that would block the CACs already built into these bonds. The thinking is that it would pressure Greece into some sort of negotiations and incremental value would be extracted. But if you are one of those investors, here is some bad news for you. If you haven’t yet exited via the 3 “doors” (above) and still holding the Foreign Law Greek bonds (after the PSI exchange and the CDS auction), there will not be a door #4. Greece will simply not pay you the coupon or the principal (unless of course you are the ECB.) Remember that by deploying the coercive exchange (CAC) on the Greek Law bonds, Greece will have officially defaulted. There is no reason for them to pay you anything, because the rating agencies will already have Greece declared in default and the CDS will have already triggered. A second default that will occur when you don't get your coupon payment will have no incremental consequences for Greece. Thus a blocking position in the Foreign Law Greek bonds is of no value, since these investors have no negotiating leverage. There is nothing they can do to Greece that hasn't already been done.

Some analysts have thought that by defaulting on Foreign Law Greek bonds after the new (“post-PSI”) bonds have been issued, Greece will trigger a cross-default, effectively defaulting on these new bonds as well. But Greece promptly took the cross-default (proposed) provision out of the new bonds. As far as the Greek government is concerned, they will only have the one new set of bonds. And if you held out on the Foreign Law bonds (and did not take doors 1-3), that’s too bad - you'll just end up getting a doughnut.

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The market is already quoting CDS on the new Greek bonds

The Greek credit event is now fully priced in. The 5yr CDS is trading at 75/78 points upfront with the cheapest to deliver bonds trading in the low 20s. The points upfront pricing for the one-year CDS is almost the same as that for the 5-year contract - typical pricing for a defaulted credit (CDS of all maturities will settle the same way). The CACs will be enforced this Thursday and the ISDA committee will rule this to be a credit event.

The Telegraph: Authorities in Athens are ready to enforce the controversial collective action clauses, or CACs, to impose the restructuring deal on all bondholders as the number of voluntary agreements look set to fall short of the required amount.

What's next? Well, some technical issues around the auction are yet to be worked out. There is also the issue of funding Greek banks which will no longer qualify for standard ECB funding.

The Telegraph: "Greek banks will probably be barred from normal ECB funding and have to turn to the Emergency Liquidity Assistance [provided by the ECB] instead but for how long, we don’t know.”

And then... the sun will rise and the world will go on as usual. The dealers are already quoting CDS on the new PSI exchange Greek bonds. These are quoted at around 20 points upfront and the bets are on for the next Greek credit event. But the markets are starting to shift focus away from Greece and onto Portugal, with volumes for Portuguese sovereign CDS picking up and spreads continuing to stay wide.

Portugal 5yr CDS spread assuming 40% recovery

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Greek CDS settlement auction is ‘lifeguards swim only’

The probability of the Greek CDS credit event (trigger) is now quite high. Once the ISDA committee makes their determination (and with CAC, they have to call it an event), the CDS settlement begins. Modern CDS are cash settled rather than via "physical". In the past the protection buyer often delivered the defaulted bond (usually could be any eligible pari passu bond from that name) in return for par payment from the protection seller. These days the settlement is done via auction of the defaulted bonds that is used to determine the bond "recovery value". That means if you hold a Greek bond and also hold protection you may still have some basis risk.

If your bond is worth say €30 and you also hold the CDS, you would expect the total value of the position to be around par. Suppose you want to hold on to your bonds (post-PSI) instead of delivering them into the auction. If the auction ends up with a recovery value of €32, the CDS will only pay you €68 (instead of 70), and now you end up with €98 instead of par. There is some basis risk between where your bond is marked and where the CDS recovery is established. That's why in preparation for the auction, some investors are using "recovery locks" - swaps that pay the difference between the expected and and the actual recovery levels once the auction is completed.

IFR has a great write-up on the topic:

Recovery locks only tend to trade in the run-up to a CDS auction. Some traders prefer to use these instruments to cover their residual risk in order to avoid volatility in the CDS market going into an auction. Five-year CDS on Greece has also pushed out over the last week by four points to 72 upfront to take into account the higher than expected haircut in the so-called private sector involvement programme that sees investors agreeing to swap existing bonds for new paper.

As discussed earlier, the markets are already pricing in the CDS trigger.

IFR: William Porter, head of credit strategy at Credit Suisse, said the market was already showing general signs of winding down. “The market is liquidating even now at the margin – the open interest is going down, and CDS is priced to an immediate event. You’re effectively conducting the early stages of the auction now,” he said.

Here is the expected timeline for the settlement. The bonds used in the auction to determine recovery will likely be the new, "post-PSI" Greek bonds.

IFR: ...the debt swap will take place on March 12, at which point the CACs will be exercised writing down bonds to 46.5% of face value, and CDS will be triggered. Domestic law bonds should therefore be exchanged for “new” Greek paper before a CDS auction is held, which have traditionally taken at least a week to organise following a credit event decision by the DC [ISDA committee]. As a result, these new bonds should be deliverable into the auction.

This settlement pertains to the Greek law bonds, while there is still uncertainty around €18.5bn of the UK law ("international") bonds. Other uncertainties remain as well, mostly associated with the actual process, given this unusual CDS settlement (vs. say corporate CDS whose settlement is commonplace.) By the time we get to Portugal or Ireland, everyone will be an expert.

IFR: “These auctions are not ‘adults swim only’, they’re ‘lifeguards swim only’ – the market is still learning as we go along. I think the Greek auction will be orderly, but the chance that something really strange might happen can never be entirely ruled out,” Porter said.

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Greek PSI outcomes tree: credit event probability at 93%

The CAC legislation has been put before the Greek Parliament.

Reuters: Greece said on Tuesday it would pass legislation that would allow it to enforce losses on bondholders who will not take part in a voluntary bond swap plan, also known as PSI, that forms part of its bailout plan.

The vote is set for tomorrow and is expected to pass. It will retroactively change the existing Greek bonds (only those under the Greek law, since a portion is under the UK law) and require two-thirds majority of the outstanding bonds to force the holdouts into taking a haircut (exchange for new bonds.) The ECB/NCBs will be excluded. Given this is an aggregate CAC (not issue by issue), the Greek banks and other "friends of Greece" holders should be able to form a two-thirds quorum (building a "blocking position" will be nearly impossible).

The BNP Paribas diagram below shows possible outcomes with the highlighted boxes representing the most likely scenario. This supports the view that the most likely outcome (as well as two others) will result in a CDS credit event (trigger) - as discussed earlier. Each final outcome on the tree has a precedent: Uruguay, Anglo Irish (bank), Northern Rock (UK lender), and finally Argentina. Only the "Uruguay scenario" does not end up triggering CDS.

Greek debt (PSI) event tree (source: BNP Paribas)

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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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In Greek restructuring some institutions are more equal than others

It is understandable that the ECB would be sitting on the sidelines of the Greek restructuring process. But a simple statement from the central bank could go a long way in advancing the stalled negotiations. Draghi needs to agree that the ECB and other public holders of Greek debt must be treated the same way as the private bond holders. The pressure on the ECB to participate in the restructuring is now coming from both sides of the negotiations as well as from the IMF.

Reuters: Athens also wants public creditors like the ECB to take part in the bond swap deal, under which banks and insurers will take real losses of about 70 percent on the Greek debt they hold in a bid to ease Greece's debt burden by 100 billion euros.

Clearly that is not happening and the expectations from the ECB (and Germany who supports the central bank avoiding a haircut) seem to be that the €40bn of Greek debt it holds will have a priority claim. The Eurozone is beginning to sound like something out of Orwell's Animal Farm - all Eurozone institutions are equal "but some are more equal than others".

FT: “The balance between the participation of the private and the public sector is a concerning question,” Christine Lagarde said on a visit to Paris on Wednesday.

Back in the 90s Orange County California defaulted on its debt. All the public and the private holders were treated the same in the process. But imagine holding Orange County commercial paper and being told that a federal government agency who holds the same paper as you will be getting their money first, while you have to take a large loss. This is particularly ugly if you weren't told about this possibility when you bought the paper. (In fact there were rumors at the time that a pension fund may have a priority claim, but they turned out to be false.) Credit markets break down in these situations and that is what the Eurozone is now facing.

It is important to note that even though the ECB losses will be substantial, the central bank bought its Greek paper at a discount, mitigating some of the impact of the haircut. But it is unlikely that the ECB would be swayed by this fact:

Capital Economics: Draghi seems very likely to dismiss the idea, probably on the basis that the ECB’s purchases were designed to ensure the proper functioning of monetary policy - by lowering long-term interest rates - and not to relieve fiscal pressures on Greece or anyone else. What’s more, haircuts would presumably make the ECB even less inclined to buy other governments’ debt. 

All good points, but by avoiding a haircut the ECB will in fact end up raising long-term rates by undermining confidence in the credit markets. It may even end up having to purchase more Eurozone bonds in the future to maintain stability in sovereign debt because of this decision.

Greek default in and of itself is not going to have a dramatic effect on the Eurozone's financial system or the economy. The losses have largely been taken and the markets have adjusted accordingly. But it is the way the process is handled that will set precedence for sovereign credit markets going forward. There is little time left and a mistake at this juncture will have lasting implications for the Eurozone.

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Der Spiegel hypes hedge funds' role in Greek restructuring - and gets the Hype Award

Mainstream media has been hyping up the hedge funds' role in the Greek restructuring process. The evil speculators are at it again, "holding out" on the voluntary exchange for new bonds. The argument goes that hedge funds bought bonds at a deep discounts and also bought the CDS protection. If there is a disorderly default or an involuntary restructuring, these funds would lose money on their bonds but more than make up for it on the CDS. Der Spiegel argues that these speculators are getting "free money" in this transaction.

Der Spiegel (Stefan Kaiser): Things look different for the hedge funds if an agreement breaks down. In this case, the threat of insolvency exists. The chance that the bondholders would get their money back would dramatically decrease. The bonds would have less value than before, and would no longer be worth €30 million, but say just €10 million. And the CDS guarantees would be due. The hedge funds would, depending on the arrangement of the CDS, receive up to 100 percent of the bonds' nominal value, or €100 million. Under this scenario, the hedge fund that invested €60 million would get €110 in return - a profit of almost 100 percent.

But let's check Der Spiegel's math. Evil Capital Hedge Fund buys a Greek bond at €30 (per Der Spiegel's comment) and a CDS protection that would cost them say €70. According to Der Spiegel the bond ends up worth €10 after the Greek default. The CDS will pay out par less the recovery amount or €100 - €10 = €90. So the trade makes them €20 on the CDS (from €70 to €90) and the bond loses them €20. Evil Capital is net flat on the trade, not up " almost 100 percent".

Some may argue that the shorter maturity CDS is cheaper than €70, closer to €60. But shorter term bonds are actually more expensive, closer to €40 (the 3/12 maturity bond is around €38). So the same math applies and Evil Capital still barely breaks even on the trade. Amazing. No free lunch here - the market is a bit more efficient than Der Spiegel gives it credit for. And Evil Capital may not be that smart after all.

Nevertheless hedge funds are still derailing the negotiations according Der Spiegel and the Greek Government won't stand for it.

Der Spiegel (Stefan Kaiser):  The Greek government, though, has threatened not to tolerate such freeloaders. If an agreement is reached with 80 percent of the bond holders, they want to force the remaining 20 percent to take part in the haircut. In that case, the existing bonds would later be so-called "Collective Action Clauses." The hedge funds could still cash in because in this case the debt repayment would not be voluntary, and it would be considered a payment default, making the CDS also come due, and the gamblers would profit.

But wait a minute here. What other bond holders may be holding out? The answer is that the other big holdout may in fact turn out be the ECB. With the support of the German government, the ECB does not want to participate in the voluntary exchange.

Bloomberg: While the ECB faces pressure to join private-sector investors in accepting losses on Greek debt, the central bank sees any participation as risking damaging confidence in the institution, two people familiar with the Governing Council’s stance said. The debt was acquired for monetary policy purposes and the ECB is firmly opposed to any restructuring, they said on condition of anonymity because the matter is confidential.

Therefore not only there is no free lunch in the Greek CDS-bond trade, but the holdouts may actually be dominated by the ECB, not hedge funds. For their focus on sensationalism rather than unbiased journalism, Der Spiegel and Stefan Kaiser get the Sober Look Hype Award. Congratulations.

And by the way, this Der Spiegel story opens with the following photo. Read the caption.

NYSE business "strained" by the Greece negotiations? And we wonder why the public is confused about financial markets.

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More myths around Greek CDS trigger risk

Significant misperceptions around Greek CDS triggers continue to persist.

WSJ: Since CDS function like insurance for debt, sellers of the protection pay buyers when a qualifying credit event, such as a default, occurs.

Again, CDS is not like insurance because it's an actively traded mark-to-market instrument.

WSJ: Hanging in the balance is the reputation of CDS as an instrument for hedgers and speculators--a $32.4 trillion market as of June last year; the value that may be assigned to sovereign debt, and $2.9 trillion of sovereign CDS, if the protection isn't seen as reliable in eliciting payouts; as well as the impact a messy Greek default could have on the global banking system.

It is true that the legitimacy of sovereign CDS settlement has been called into question because of the ability of governments to influence the "event of default" and conflicts of interest around the ISDA Committee. However the impact on the "global banking system" of Greek CDS triggering is minimal because banks who wrote protection have already marked these positions to market (as required by the US GAAP and IFRS).

By not triggering CDS, some have argued, the evil "speculators" who bought protection to bet against Greece will be punished because they will not get paid. And that supposedly would discourage others from "betting" against periphery sovereigns going forward. This is another misnomer because these so called speculators already made their money - they don't need to wait for the CDS settlement or maturity.

CDS holders who wanted to take profits simply sold their protection in the same way that an equity put holder can sell her put without exercising it and still make money when a stock drops. In fact some of the CDS holders have been taking profits causing Greek CDS to tighten some.

Greek 5-year CDS spread equivalent (Bloomberg)

Plus "betting" against a sovereign does not require a CDS.  Shorting government bonds in the repo markets is even easier than using CDS because bonds are usually more liquid. A repo agreement is simpler to set up than an ISDA agreement.  One can also achieve comparable or sometimes better  leverage in the repo markets to what one would obtain using CDS. In fact that's exactly how MF Global leveraged their sovereign bond positions.  So this whole concept that CDS somehow affords magical leverage capability unavailable elsewhere is a myth.

Another issue that continues to spook some people is the idea of counterparty risk.

WSJ: While the net volume of CDS outstanding is small at $3.2 billion, the gross amount--referring to the daisy chain of CDS bought and sold in the aggregate across financial market participants--tops $70 billion. If one of the those trading parties can't make good on its financial obligations, it could shake confidence in the system very quickly with potentially disastrous consequences.

Again, CDS is not like an insurance contract - in fact it trades more like futures. That means that counterparties are subject to variation margin which they post on a daily basis.

WSJ:... 93% of respondents to a recent International Swaps and Derivatives Association survey said their credit-derivatives trades were subject to collateral arrangements during 2010, which would cushion the blow.

During 2011 that proportion increased further with even some of the stronger banking institutions in Europe forced to post margin.

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