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It's Not So Easy To Get Away From This Voluntary Greek Bond Swap

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Bloomberg reported today that, back in July, David Einhorn and some other people decided that (1) betting against European sovereign debt was, and would remain, a good idea, but (2) doing it in CDS form was kind of dumb, so (3) they'd switch to doing it in physical form, by borrowing and shorting the debt. Here's what Einhorn had to say in his July investor letter:

The letter touched on two risks tied to credit swaps on European sovereign debt, including regulators’ attempts to fashion a Greek bailout in a way that prevented the contracts from paying out. The second risk was the possibility that banks that wrote billions of dollars in credit swaps on sovereign debt might not be able to make good on their obligations should a country such as Greece actually default.

Let's talk about that first reason for a minute because I think it's sort of illuminating. The problem is that Europe was in July, and is now, and wow that's depressing, trying to cobble together a "voluntary" debt exchange where holders of Greek debt happily hand it in to Greece and get back a thing with a 50% face value haircut that is also a piece of crap. If you're a European bank who owns Greek bonds and CDS to hedge them, and you feel pressured to accept that deal, then you feel like the "insurance" you bought on your bonds should "pay out," I suppose, though that's all fairly hypothetical. If on the other hand you're David Einhorn and you bought CDS and then Greece haircuts its debt, you feel like your bet against Greek debt has been vindicated so it should pay out. But it doesn't, says ISDA, because the exchange was voluntary and there was no "credit event" under the rules governing your CDS.

Now you can feel some feelings about this - you can think it means the end of the CDS market, or that it's no big deal; you can think that ISDA's determination that this "voluntary" exchange is not a credit event is clearly right, or that it's an evil conspiracy; and of course you can have a range of views about the likelihood of the voluntary exchange happening and about whether, after the voluntary exchange, any un-exchanged bonds will be paid at par or forcibly defaulted.

But you can avoid all that and just short the bonds, which seems to be what Einhorn did. Here Einhorn goes to his prime broker, borrows some Greek bonds, and sells them. In six months, when the bad thing has happened, he buys them back for cheap and returns them to the dealer. That is all straightforward. What could be easier.

Well, you might wonder what happens if, I don't know, the bonds that he borrows are transformed into something else. This might be relevant to you if you are borrowing Greek bonds, which everyone expects to be transformed into something else. (Specifically smaller, crappier Greek bonds.) Securities lending agreements typically provide for this in the expected way - you don't return the securities you borrow, you return "equivalent securities," and

If and to the extent that such Loaned Securities ... consists of Securities that are partly paid or have been converted, subdivided, consolidated, made the subject of a takeover, rights of pre-emption, rights to receive securities or a certificate which may at a future date be exchanged for Securities, the expression shall include such Securities or other assets to which Lender or Borrower (as the case may be) is entitled following the occurrence of the relevant event. ... In the event that such Loaned Securities ... have been redeemed, are partly paid, are the subject of a capitalisation issue or are subject to an event similar to any of the foregoing events described in this paragraph, [long-winded but entirely reasonable things happen].

So, fine, if Greek bonds transform into other Greek bonds, Einhorn returns the other Greek bonds.

But ... they don't. Under the voluntary regime anyway. There, nothing has transformed into anything - some people have just agreed to do a trade. Einhorn's obligation remains what it was - to deliver back the Greek bonds he borrowed, not the ones that those bonds could have been exchanged for.* It is hard to imagine him saying to a securities lender "oh, hey, yeah, I exchanged your bonds for you, hope you like these smaller crappier bonds." He just doesn't get to do that with the lender's bonds. And if he tried - well, I think his prime broker would be a lot more conflicted than the ISDA determinations committee.

You can if you like imagine how this impacts the trade. Einhorn borrows bonds and shorts them. Greece deteriorates and voluntary plan gets uglier, so they drop in value. He has a mark-to-market gain. Voluntary plan is executed. Some bonds are gone. Others remain. When Einhorn wants to close out the position, he has to go buy in those remaining bonds. Their price will depend on whether people now expect them to hard default, or to be paid off, plus I guess on their post-exchange scarcity and how crowded this trade was. If a hard default is likely, or occurs, the short seller makes lots of money. If the stub of bonds not voluntarily exchanged are expected to be paid at par, the short seller loses money.

These are exactly the cash flows you'd get from buying Greek CDS.

None of this happens of course - David Einhorn doesn't enter into a term borrow of bonds, short them, forget all about them, and return a year later to scramble to buy back those bonds. An actual short seller would buy in the bonds and close out his short just before the voluntary exchange, when they're cheap, and even if he didn't want to his borrow would likely be called in by his prime broker who is, after all, a big bank who feels pressured to participate in the voluntary exchange.

But everything is just the present value of the thing it will eventually be, so this should cast a shadow over current trading levels - if post-exchange bonds are gonna do great, then the bonds should trade above their exchange value. (If not, not.) And the equivalency is worth keeping in mind when you see people freaking out about how broken CDS is. (Sometimes. None of this has anything to do with Einhorn's other reason for moving to physical, which is the contagion risk of the banks who write the CDS maybe having written too much of it. That is a whole nother kettle of fish.) CDS levels should more or less track bond yields because they should more or less replicate the experience of short selling bonds - and it's harder to disconnect the two than you might at first think.

Einhorn Trades Swaps for Shorts When Betting on Sovereign Debt [Bloomberg]

* Technically section 6.7 of the standard securities lending agreement provides that on corporate events that require an election, the lender should be able to make the election - so if this falls under that category the prime broker could tell Einhorn whether they want the original bonds or exchange bonds back. It's not at all clear that it does fall under that category, and in any case you'd expect them to elect the original bonds.


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 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.**