So Maybe Greek CDS Won’t Be Fine, Who Knows, I Give Up

ISDA decided today that there has been no credit event for purposes of Greek CDS. Obvs! And by “obvs!” I mean what I said the other day, which is that with 100% certainty there’s been no credit event yet, but with 100% certainty there will be, so everyone should just chill out.

Except that it seems like that last part may be wrong. So go ahead and panic.

I used to make convertible bonds and some of my time was spent answering questions about what happened to things upon Events. The most popular was: what happens after a merger? If you have a convertible that converts into 10 shares of XYZ stock, but now XYZ is being acquired and each share of XYZ is being acquired for $30 in cash and 4.5 shares of PQR stock and a pony – what happens to the convertible? And the answer I would give usually started with “don’t trouble your pretty little head about it.” Like, it’s fine: you have a convertible that converts into 10 Things, and before the merger each Thing was an XYZ share, and after each Thing is exactly what an XYZ share transformed into, so you convert into $300 and 45 PQR shares and 10 ponies. It just works because it has to work. Economic interests follow without interruption from changes in form; derivative securities poof into derivatives of things that the underlying poofs into. There is no arbitrage!

That assumption is central to doing any sort of derivative work, and it spoiled me a bit. Sometimes people would come up with more complicated scenarios involving dividends, multiple-step transactions, weird splits and spinoffs and sales, etc. etc. And I would generally start from the bias “it has to work, so I am sure the document written in the way that works.” Where “works” means “the economics and intent of the trade are preserved after the change in form.” But of course the document was written by humans, often specifically me, and those humans, often including me, are fallible. So there may well be documents from my former line of work that don’t “work” in the sense that an issuer could do some structural tricks that would screw holders out of their economics – where the derivative doesn’t follow the underlying everywhere it might go. These tricks are unlikely enough that I don’t lose sleep over them. You can’t predict everything.

I sort of assumed that Greek CDS also had to just work but here is Felix Salmon at Reuters saying no. Lisa Pollack at FT Alphaville said something similar a week ago but I could not fathom that she meant it so I read it to mean something else. But she means it, and Felix does too. Go read it but the basic gist of this theory is:

(1) Right now you have Old Greek Bonds with a face value of 100 and a trading value of like 25
(2) They will be exchanged for (a) New Greek Bonds with a face value of 30 and a trading value of like 10 plus (b) EFSF bonds with a face value of 15 and a trading value of 15
(3) But the CDS auction will happen after this and the deliverable obligation specified by the CDS contract is just “Greek bonds with a face amount of 100.”
(4) So that will mean New Greek Bonds with a face value of 100, which will have a trading value of 10/30 x 100 = 33
(5) So the CDS reference price will end up being 33, for a payout of 67 cents on the dollar rather than 75
(6) So if you had a bond + CDS, then you get 25 on the bond and 67 on the CDS for a 92 total
(7) Which, you will notice upon careful examination, is less than 100
(8) And you could monkey with that even more by for instance having New Greek Bonds with a lower face value and higher coupon, so that they might have a face of 10 and a trading value of 10, meaning that the CDS auction would clear at par and there will be no payout.

So as Felix says:

What this means is that the CDS architecture is broken, and can’t cope with collective action clauses. And as a result, according to the hedge fund manager who tipped me off to the whole problem, “this Greece CDS imbroglio might be the final blow for sovereign CDS as a product.”

Now there is a possible solution here: ISDA could try to decree, somehow, that the total package bondholders receive in return for their old bonds will count as a deliverable security for the purposes of the CDS auction. Bundle up the new bonds, the EFSF bonds, the GDP warrants, everything — and that bundle can be bid on in the auction, to determine where the CDS pays out. That would be fair and right. But the problem is, it might not be legal. There’s really nothing in the ISDA CDS documentation which explicitly allows that to happen.

That is amazing! I was skeptical because, well, first of all, I am sick of “final blows for sovereign CDS as a product” and usually so is Felix. I was also skeptical because this just cannot be right – it cannot be the case that a collective-action exchange from $100 in face value to $1 in face value (but trading at its $1 par) would lead to no loss under CDS contracts. There is no arbitrage! And that’s just a stupid-easy arbitrage.

But just because something just cannot be right doesn’t mean it’s not right. Sadly I’m not a CDS expert so I can’t really weigh in on this one with any authority. Hopefully others can. I am an overconfident guy who reads documents so I’ll probably give it a shot in a future post. For $350 you can buy the ISDA Credit Definitions and play along. (Check out “Sovereign Restructured Deliverable Obligation”!)

The minimum you can say though is that it seems like quite a murk, so you could understand why some people are confused – like Bill Gross, who objects to the ISDA determination that PIMCO voted for. So I take back my recent claim that everything’s fine with Greek CDS: people want a credit event declared and the settlement settled before all the murk happens. And it looks like they are not going to get their wish. Leaving them with murk.

That said, though, this probably doesn’t mean The End Of The Sovereign CDS Market. (Quick test: why sovereign? The same exact thing would apply for a collective-action restructuring of non-sovereign bonds. Is this The End Of The Corporate CDS Market too?) Rather, I suspect it means The Beginning Of Changing The ISDA Credit Definitions.

At least in my experience one thing that financial markets participants really quite like is predictably achieving the right result – and here, at least, there is no serious debate about what the right result would be. It’s just that the humans involved in crafting the (91 page) credit definitions … mmmmaaaaayyyyybe didn’t quite get there on this one. Which is understandable: you can’t predict everything, and who would have predicted the particular kettle of fish that Greece has found itself in? But tomorrow is another day, and ISDA will get a chance to fix whatever is … let’s say “murky to broken” … here in future contracts. Lucky that this came to light before it was tested in anything high-profile, no?

How Greece’s default could kill the sovereign CDS market [Felix Salmon / Reuters]
Will the Greece CDS auction be ‘fair’? – Part 1 and Part 2 [FTAV]
Greece CDS: trigger sad [FTAV]
ISDA Credit Definitions [best $350 you’ll ever spend!]

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Show all comments

64 Responses to “So Maybe Greek CDS Won’t Be Fine, Who Knows, I Give Up”

  1. Just Curious says:

    Aren't doc clause arbs what convertible trading is all about?

  2. UBS Middle Office says:

    there is a terrible moment, when you start reading Matt's post, and you find them kinda interesting…but then you scroll down and look at the sheer volume, and say "Do i really want to read this?" I usually just start reading the comments instead

  3. anonhfm says:

    I tried to explain this in the comments to your last post! ISDA will definitely try to sweep this under the rug, because by pure luck the likely CTD bond (the longest of the 20 new GGB) is trading in the w/i market within one point of where the w/i market for the whole package of 20 new GGBs + 1 warrant will put recovery on an old GGB. Talk about inverse Murphy's Law. They'll declare an event on March 9, when Greece invokes CACs (don't see how anybody could wiggle out of that one and not expect major legal shitshow and the end of CDS), true recovery will be 24, Auction will settle at 25, and ISDA will say, "see, it all worked out!"

  4. VonSloneker says:

    Good god man, autoeject "obvs" in the first sentence…now I'll never know what Matt "The Machine" Levine thinks about the ISDA ruling…

  5. Guest says:

    I have no idea what's going on.

  6. Point says:


  7. ZeroNegativeFoxtrot says:

    Well, I would just like to take this opportunity to say that the wet t-shirt picture is still making me all antsy in the pansty.

    Other than that, I have no idea what Matt is talking about.

  8. Mexi_Cant says:

    Matt please help explain this:

    In the comment section, D.Evan writes: "Lets see, he spent 26.5 B and now got a payout of 1B. But, only 775M of that payout is due to the 26.5B investment. By my math that comes out to less than 3%. Hardly the earth shattering returns expected from a "legend". "

  9. trojan_ says:

    is there already a drinking game with a shot for every "like"?

    • VonSloneker says:

      Like, for sure. We, like, came up with it on set in the early 80's. Roll tape…Bartles & James wine coolers…it's, like, totally tubular…

      – Nick "Randy" Cage

    • Drunk says:

      9 shots today

  10. Tanker2Banker says:

    Too long, didn't read past the pony reference. Felt slightly like a (insert CFA/MBA/High School/Gradeschool as appropriate) flashback.

  11. On Another Note says:

    Remember Kouwe?

  12. Guest says:

    I hate it when rookies try to get cute.

  13. Sleeper says:

    This XYZ company sounds promising but I can't find it on Bloomberg.

    – UBS Trader

  14. Strong sell says:

    "Say 'like' again. Say 'like' again! I dare you, I double dare you mothaf*****!"

  15. Pickles says:

    Export more Oikos. The world neeeds more Oikos.

  16. Chart Lover says:


  17. Germany says:

    Greece Sucks….lazy losers, sound like people working at Lehman

  18. Grecians says:

    That's all we are saying Matt, is give greece a chance.

  19. Mercury says:

    I can't really knock Matt for writing what he wrote the other day…I mean that's what should be happening…but I think he missed the forest for the trees. This shit is real. Allow me to quote myself at leanth from the previous comments thread:

    "I’ll believe that Greek sov. CDS pays out on said defaulted (creditors don't get payed what they're owed) bonds after it actually happens thank you very much. You’ll recall that we are now living in a world where central planners are very much in the habit of arbitrarily altering well established bankruptcy procedures as is politically expedient and bringing endless legislation into existence by executive fiat while fighting an ultimately hopeless battle against crushing debt…with more debt."

    The rule of law, contitutional protections against governments and fair, transparent markets continue to crumble before our eyes. And it's going to get worse. We'll see what happens with the PSI.

  20. The Grand Marquis says:

    Which fake trade tickets can I mark-up?, this is ridiculous!

    -UBS Prop

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