If You're Not Into Greek CDS Any More, Maybe You Can Buy This Monstrosity


We've noted here before the irony that Europe is both (1) screwing with your ability to get paid on CDS on shaky European sovereign debt (sort of) and (2) hoping people will buy more shaky European sovereign debt because they can get tradeable first-loss protection, suspiciously reminiscent of CDS, from the EFSF on those bonds. The further irony is that, at the same time as it's touting the free transferability and liquidity of that first-loss protection as a selling point, Europe is moving to restrict investors from owning sovereign CDS unless they can prove they really need it, to hedge sovereign debt or correlated assets.

Today FT Alphaville has the details on the potential EFSF-issued first loss protection (full Q&A here). The plan would be to let member states who are "under market pressure" to issue bonds along with "partial protection certificates" that would, on a payment default on the underlying bond, pay off an amount equal to the principal loss on the bond, up to some cap. The EFSF is coy on the cap but admits it might be around 20% of the bond's principal. The payoff would be in the form of EFSF bonds, which are currently AAA rated: so if your Spanish bonds, say, only pay off 50 cents on the dollar, you'd get an extra 20 cents face value of AAA rated EFSF bonds of unspecified terms.

Importantly, these certificates would be freely tradeable:

E21 - Doesn’t this scheme segment the sovereign bond market?

The bonds issued by Member States under this scheme will be identical in every respect to existing bonds issued by that country. This is the reason why the partial protection certificate could be detachable and separately traded.

E22 - How does EFSF expect the newly-issued bonds to trade in relation to existing bonds?

The bonds will be identical to existing bonds and are expected to trade in line with them. However the actions of the EFSF in support of sovereign bonds for that country is intended to have a positive impact on investors’ perception of all sovereign bonds issued by that country.

More importantly than that happy language in the last sentence, the certificate will cheapen the rate on any issue that it's actually stapled to, in about the same way that a CDS contract with a 20% payout cap would. So who needs CDS, right?:

E24 - What will be the effect of this scheme on the CDS market for the Member States?

That is a matter for investors, who will have different preferences; the two instruments are not identical. The partial protection instrument offers superior protection as a risk management tool to a CDS in a certain respect, as explained above [because the EFSF is a AAA rated counterparty, while your CDS counterparty is Dexia or something].

If you're hung up on intellectual consistency, you might ask, will Europe ban "naked partial protection certificates"? That is, will you have to prove that you hold Spanish government debt, or other debt correlated with it, in order to buy one of these freely transferable certificates protecting Spanish debt? I don't think there's any official answer on this one way or another - the rules banning naked CDS are in flux and the draft I've seen, which defines CDS to involve running premium payments from the protection holder, more-likely-than-not wouldn't cover this partial protection beast.

But the answer is sort of obviously no. European leaders can turn a deaf ear to claims that regulating who can buy CDS will screw with the liquidity of that market and raise the cost of issuing sovereign debt, as long as that market is more or less private; they are much less likely, though, to take affirmative steps to screw with their own rescue plan. You can bet that, if the partial protection certificates become a reality, they will be freely tradeable in the sense of "actually freely tradeable": if you want to buy one, split up from the underlying debt, you can go right ahead without submitting to a body cavity search by European officials to discover any net short sovereign exposure.

That makes political sense but it's a bit financially screwy - why ban speculators from betting on Spanish default by buying Spanish CDS, but allow them to bet on Spanish default by buying EFSF-sponsored Spanish quasi-CDS? One way to make sense of it is by thinking about the instruments' delta to Spain and, more so, to Europe. Here we can just use "delta" casually to mean "when Europe goes up, does your thing go up a lot or a little, or down a lot or a little, or squiggle around a bit, or other?"

If your model of European policymakers is "they viscerally hate anyone betting against Europe," then the more delta that bet has to Europe going down the tubes, the more hateful it is. Buying Spanish CDS from an American bank - which let's just hypothesize is uncorrelated to Spain, though, maybe not - is a pretty delta-one bet against Spain. Every dollar that Spanish bonds fall should be a dollar you make on your naked CDS. Your rooting interest is against Spain, and Europe, all the way down.

But buying an EFSF partial protection certificate is not quite as clear a bet. Not, mainly, because it's partial - that doesn't really matter if you're buying it "naked"; if you pay $5 for a thing that pays off up to $20 on a Spanish default, then you're still happy to root for a Spanish default, though you do have less incentive to root for a disastrous default than you would if you paid $15 for a thing that pays off up to $100 on a Spanish total burn-it-down-and-salt-the-earth-it-stood-on default.

But because it's still European credit. On a Spanish default, you don't get money - you get an EFSF bond. The EFSF is backed by guarantees from member nations, and as those nations go so goes the EFSF, mostly. As FT Alphaville puts it:

We’ll admit, a trading desk could simply plug in the AAA rating to determine the credit risk of the protection… But this is 2011, not 2006, and we think their risk managers would seriously chew them out for it. Again, this comes back to the wrong-way risk embedded in the EFSF. If Italy does default, it will hit the guarantee structure of the fund pretty horribly. (Hopefully, this is fairly clear by now.) As a PPC holder protected on 20 per cent of a principal write-down, you’re actually perched upon an EFSF equity ‘tranche’ which could be burned though pretty quickly by a country of a significant size defaulting, especially considering the size of defaults that are likely to come before.

You can call it wrong-way risk - and you would call it that, if you were buying it to hedge a European sovereign default. But for a policy maker you could think of it as "a delta much less than one, and at some points less than zero," or maybe as "a quite kooky exotic derivative on linked Spanish and pan-European credit." If you found yourself in possession of a partial protection certificate on Spain, and Spain then had a contained default where it wrote down its debt by 20% or more while the rest of Europe trucked along happily, then you'd be quite pleased with yourself, and your partial protection certificate would go up in value pretty much one-to-one with Spanish bonds falling in value. But if instead Spain had months of convulsions while everyone talked about contagion and spreads on every other European nation gapped wider, then you'd be quite a bit more nervous. Your partial protection might go up in value as Spain started to teeter, but not on a one-to-one basis, and it would likely drop in value as things got worse and the whole edifice started to look shaky.

I doubt that this is explicitly how European policy makers think. (For one thing, I'm not sure that the EU folks writing the CDS rules and the EFSF folks writing the partial protection plan have even met each other.) But you can imagine its appeal: Europe will hunt down without mercy anyone who bets against Europe, but will cut some slack to anyone buying these EFSF thingies "naked" - because they have a good chance of ending up in the same soup as people who went long on Europe.

How badly do you want EFSF first-loss protection? [FTAV]

European Financial Stability Facility Q&A [EFSF]


So Maybe Greek CDS Will Be More Than Fine?

Gaaaaaaaaaaaaaaaah Greece. Okay so all systems appear to be go on the Greek debt exchange, which means its time to decide What This Means, and, I just. Really. Greece. Come on. All I want is to talk about 13D reporting requirements, and now I have to pay attention to Portugal? No. Just no.* Still here is arguably a fun factoid: On Wednesday, Swiss bank UBS AG started quoting a "gray market" in new Greek sovereign bonds ... using as a guide details of the debt swap Greece has put on the table for private investors to accept until Thursday evening. The "bid" price for a batch of future Greek bonds due in 2042, or the highest price the dealer was willing to pay, was around 15 cents on the dollar; the "offer" price, or the most the dealer was willing to sell at, was 17 cents on the dollar, the first person said. ... The prices quoted by UBS imply that losses private creditors to Greece will take are more like 79% of face value, not the original haircut of 70-75% many had expected. Yeah but. If you believe this horrible CDS mechanics stuff that various people including me have been yammering about for weeks - here is the best explanation - that means that if for some reason you had the foresight to be long Greek bonds and hold CDS against them you'd end up with a package worth (1) 21 on the bonds and (2) 83 on the CDS (assuming that the 17 offer for the 2042 bonds represents a real price for the cheapest-to-deliver new bond in the Greek auction) for (3) 104 total which is (4) more than par, so you win this particular game, yay. Which you were at risk of losing - a week ago one of our fearless commenters spotted the longest new bonds at 25ish vs. 24ish for the old-bond-y package, for a total of 99 for the hedged holder - losing 1 point versus par.**

One Last Greek CDS Post Before It All Goes Poof

One of the side benefits of Greece taking whatever somewhat irreversible steps it is now taking is that something will happen to CDS written on existing Greek debt and that will mean that we can stop talking about what will happen to CDS written on existing Greek debt and start talking about more interesting things like quasi-CDS written by the EFSF on shaky Eurozone government debt. For now, though, we've got at least a few more weeks of surprisingly and unsurprisingly ill-informed fretting that triggering the $4bn of Greek CDS will Bring Down The Entire Global Financial System. That seems sort of silly because notionals aren't that big, mark-to-market collateral is mostly being posted, and at this point the marks are pretty close to what you'll get from Greece so it doesn't look like there's tons of unknown unrecognized losses lurking out there. On the other hand, we're mostly through with the speculation that not triggering Greek CDS will Prove That CDS Is Worthless and thereby Bring Down The Entire Global Financial System, so that's nice. The reason that's mostly over is that it sure looks like Greek CDS will in fact trigger, as Athens has moved to adopt a collective action clause that will flip the Greek restructuring from "voluntary, heh heh heh" to "involuntary" and thus trigger the ISDA restructuring event definition. You can argue that the mechanics of the cash settlement auction will mildly screw CDS holders but I'm not so sure, and in any case this is pretty solidly in the category of derivatives nerdery rather than Bring Down The etc.

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:

This Is The Last Greek CDS Post Ever*

There's that famous scene in Liar's Poker - are there non-famous scenes in Liar's Poker? - where the much maligned equity department sends a program trader to impress Michael Lewis's jackass fellow Salomon trainees with his brilliance. It does not work: He lectured on his specialty. Then he opened the floor to questions. An M.B.A. from Chicago named Franky Simon moved in for the kill. "When you trade equity options," asked my friend Franky, "do you hedge your gamma and theta or just your delta? And if you don't hedge your gamma and theta, why not?" The equity options specialist nodded for about ten seconds. I'm not sure he even understood the words. ... The options trader lamely tried to laugh himself out of his hole. "You know," he said, "I don't know the answer. That's probably why I don't have trouble trading. I'll find out and come back tomorrow. I'm not really up on options theory." "That," said Franky, "is why you are in equities." This is totes unfair to the actual equity vol traders I know, but I kind of felt like that guy after talking to a CDS lawyer yesterday about this craziness in Greece. It went something like this: Me: As an equity derivatives guy, I expect derivatives to transform into derivatives on whatever their underlying transforms into. And I'm troubled by them not doing that. Lawyer: You should not be troubled by the concept of cheapest to deliver. Yeah fair! That's the thing about CDS. Dopes like me think of it as just a rough proxy for default risk but when things get real like with Greece it turns into a cheapest to deliver convexity play and then I slink away in embarrassment. But yeah, as a matter of rough justice, if you can go be opportunistic about finding the cheapest to deliver bond, Greece can go be crappy about leaving you with only expensive to deliver bonds. I guess.