Understanding Greek CDS in a restructuring

I expect a soft restructuring sometime in 2011 followed by a certain degree of dithering and a hard restructuring down the line. But, of course, the tail risk is there.

In the event of a Greek default, I am less concerned about Greek credit default swaps and more concerned about what that CDS trigger means for balance sheets and the potential for contagion. All evidence is that CDS exposure is quite small. For example, a friend sent me a transcript of a Tom Keene/Ken Prewitt interview with Saul Doctor. Here is an excerpt. I have underlined the important bits:

Saul Doctor, JP Morgan research analyst, walks Tom Keene and Ken Prewitt through the complexities of credit default swaps on Greek government debt and why some short Greek paper may actually be a good buy.

Q: Tell us the distinction between actual government bonds and credit default swaps. What is the the relative size of peripheral Europe’s bond market and the credit default swaps on this debt?

A: If you look at the notional outstanding on Greek government or government bonds – CDS on government bonds throughout the western European sovereigns – and compare the sort of net notional of CDS contracts versus the actual sort of net amount of government bonds that we see outstanding, you are probably looking at somewhere in the region of sort of one to about five percent of the actually outstanding of sovereign bonds, which you see in the CDS market.

Q: Well, how does that compare to the worries that we had over AIG? Is there a parallel or is it a different kettle of fish?

A: I think the outstanding you see in government bonds is significantly bigger than what we see in the CDS market. In corporates, it is sometimes different. In corporates, you can see up to kind of 20 percent, sometimes even 100 percent of the notional of outstanding bonds. You can see a similar amount in the CDS market. But when you are talking about sovereign bonds, the CDS market is significantly smaller, the volumes are much less, and relative to the liquid government bond market it is just a lot smaller. It does get obviously a lot of attention and many of the holders of sovereign CDS are fairly vocal in their views. But if you actually look at the numbers, it is a pretty insignificant market.

Q: Should the IMF, the various institutions in Europe manage this crisis focusing on the bonds? Or should they focus on the elites that hold those derivative instruments?

A: It is important to focus on both really. As I said, you know, CDS is very small. In the case of Greece, it is probably somewhere about sort of one to two percent of the notional outstanding. But the holders of those CDS positions can be fairly vocal in their views. You look at corporate treasurers and how they have dealt with these problems in the past. And in many cases the amount of CDS holders is obviously bigger. But it is a very kind of easy group of people to get onside if you are going through any restructuring offer. All you have to do essentially is create a CDS trigger and all of those bondholders who also hold CDS against those positions will pretty much be happy to sign up to whatever restructuring you are going to offer because as long as they get their CDS trigger, they know they are going to get asset par. So I think in the government bond world as well, it is worth kind of taking that into account that CDS holders will be encouraged by any restructuring offer that is presented to them as long as they can trigger their CDS contract. At the same time, I don’t think governments are going to care that much because at the end of the day, it is a pretty small percent of the outstanding notional.

Q: This problem with Greece surfaced about a year ago. Was the market predicting it? Could you see price movement well in advance of the efforts to bail out Greece last year?

A: You saw it both in the CDS and in the bond market. CDS spreads were widening, and government bond yields on Greece versus Germany, for example, were also increasing. To say that one market spotted it earlier than the other, I am not sure. But you definitely saw both markets widening out and showing there was a lot more risk for a default in Greece and other European sovereigns as well.

Q: Would you buy Greek paper here with those wonderful yields?

A: You’ve got to be a bit careful about what maturities you are looking for. You know, probably some of the short dated stuff is going to be okay. But the longer dated stuff might see some significant write downs. It is a difficult question at the moment. You are basically taking a punt on European legislators and regulators and how they think the best outcome for Greece and Greek government bonds is. So it is not really kind of market trading, it is really kind of trying to trade political will at the moment.

I would also recommend the following article from Bloomberg: Greek Hunt for Debt ‘Holy Grail’ Pits ECB Against Naked Banks: Euro Credit. It gets to the granular bits in Greek CDS as well as CDS in other markets like Italy and Ireland.

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It is not the CDS itself but rather that the CDS trigger would imply an immediate writedown of Greek debt and that a sovereign default could create worries about defaults elsewhere in the euro zone periphery, so-called contagion. This is what I wrote when I last discussed the credit default swap issue:

The potential for CDS to be triggered even in a soft restructuring changes the calculus immensely, because that means losses will immediately be crystallized rather than spread out over a number of years as financial institutions recapitalize. We shouldn’t underestimate the difficulty this would create in money markets.

What does this mean for policy makers then?

  • If CDS are not triggered by a soft restructuring, then we will see a bond exchange for Greece that extends maturities and cuts rates.
  • If CDS are definitely triggered by a soft restructuring (maturity extension and interest reduction), then governments need to get comfort on the exposure to CDS and Greek debt by their domestic institutions. If the exposure is manageable all around, the soft restructuring can proceed. If it is not, then another bailout from the EU/EFSF/IMF facility is coming – followed by recapitalizations in anticipation of an eventual restructuring.

The CDS problem adds a whole level of complexity to the sovereign debt crisis in Europe. In my view, a CDS trigger could produce a Lehman-style event, yes.

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The caveat here is that it could do only if you get contagion or if CDS are triggered by a restructuring and governments fail to get comfort on the exposure to CDS and Greek debt by their domestic institutions. Do I expect this to happen? No. I expect a soft restructuring sometime in 2011 followed by a certain degree of dithering and a hard restructuring down the line. But, of course, the tail risk is there.

As I keep saying, this is really a political question. It’s about the political will of recognizing Greece’s insolvency and taking the right steps to prevent worst case outcomes.

UPDATE: A friend sent me the following comment on U.S. bank exposure to CDS:

Michael Lewitt (Credit Strategist) wrote (6/16) that “U.S. banks have written $34.1 billion of CDS protection on Greek debt (as well as $54.0 billion on Ireland and $41.2 billion on Portugal).”

The CDS market is opaque, so the level of exposure is still not clear. But the mandate is the same: governments need to get comfort on the exposure to CDS and Greek debt by their domestic institutions.

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4 Comments
  1. Anonymous says

    I think you are being over optimistic again. A soft restructuring will lead to a hard restructuring as the terms  will not be sustainable. It is a method of kicking the can down the road to the point the insiders can get out, leaving everyone else with the losses. The problem is the existence of CDS means that different parties have different objectives. Those who initially bought the bonds took insufficient care because they new they could get insurance against the risk. Then the CDS writers also were reckless because they expected to never having to pay out, as defaults would not be tolerated. So for them it was money for old rope, getting paid for something that was never going to happen. Now that defaults look certain they are probably facing bankruptcy if they have to pay out. 

    Also without a CDS market the US would be barely affected. Though with it there will be serious problems as to who is covered and who is liable? Then once default becomes a reality the criminal authorities will probably start to look into the activities of the US banks hiding greek debt to allow entry into the eurozone. 

    As I have said before the issue of contagion is moot. The big banks are all infected, the only issue is whether it will be fatal. Ireland might find default a much more attractive opttion once Greece defaults. In fact if Ireland lets go of the banks creditors completely, they may be able to avoid a sovereign default. The problem will be who will pay for the banks losses? These will revert to France Germany Belgium and the UK. This will force these countries to deal with the problems. I suspect that they will be bailed out and the losses socialized. In fact in three years I suspect we could be looking at a new crisis within the UK and Germany as the austerity creates problems there. 

    1. Edward Harrison says

      Leave it to you to call me over-optimistic!  You could be right, though. I think the right approach for investors to take is to hope for the best but prepare for the worst.

      1. Anonymous says

        I have been much more pessimistic than many commentators, yet I think I have been right all along. The recovery was always going to be L shaped with so much debt not being written off or being written off so slowly that it hampers recovery. The fiscal measures while great in theory have been badly designed and were almost designed with the sole prospect of undermining Keynesian policies. With Keynesian policies no longer available the only solution left is more neo-classical policies and that is why I expect things to get worse. 

  2. Anonymous says

    I think you are being over optimistic again. A soft restructuring will lead to a hard restructuring as the terms  will not be sustainable. It is a method of kicking the can down the road to the point the insiders can get out, leaving everyone else with the losses. The problem is the existence of CDS means that different parties have different objectives. Those who initially bought the bonds took insufficient care because they new they could get insurance against the risk. Then the CDS writers also were reckless because they expected to never having to pay out, as defaults would not be tolerated. So for them it was money for old rope, getting paid for something that was never going to happen. Now that defaults look certain they are probably facing bankruptcy if they have to pay out. 

    Also without a CDS market the US would be barely affected. Though with it there will be serious problems as to who is covered and who is liable? Then once default becomes a reality the criminal authorities will probably start to look into the activities of the US banks hiding greek debt to allow entry into the eurozone. 

    As I have said before the issue of contagion is moot. The big banks are all infected, the only issue is whether it will be fatal. Ireland might find default a much more attractive opttion once Greece defaults. In fact if Ireland lets go of the banks creditors completely, they may be able to avoid a sovereign default. The problem will be who will pay for the banks losses? These will revert to France Germany Belgium and the UK. This will force these countries to deal with the problems. I suspect that they will be bailed out and the losses socialized. In fact in three years I suspect we could be looking at a new crisis within the UK and Germany as the austerity creates problems there. 

    1. Edward Harrison says

      Leave it to you to call me over-optimistic!  You could be right, though. I think the right approach for investors to take is to hope for the best but prepare for the worst.

      1. Anonymous says

        I have been much more pessimistic than many commentators, yet I think I have been right all along. The recovery was always going to be L shaped with so much debt not being written off or being written off so slowly that it hampers recovery. The fiscal measures while great in theory have been badly designed and were almost designed with the sole prospect of undermining Keynesian policies. With Keynesian policies no longer available the only solution left is more neo-classical policies and that is why I expect things to get worse. 

  3. John Haskell says

    I have heard of a “soft restructuring.” I have also heard of Cyclopes. But I have never seen either.

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