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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!]