Greek CDS Would Be Fine If People Would Just Leave It Alone For A While

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Somebody once said that "The Greek CDS situation is sort of puzzling, but it’s possible, and popular, to overstate its puzzlingness." People just cannot resist doing that can they?

CDS is sort of simple. Here is the lifespan of CDS:

(1) You buy a CDS contract on undefaulted bonds in sunny times.
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.
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(n) Those bonds default and you get a payoff. (Or they don't and you don't.)

In the middle things happen. Those things live in your heart and mind and the trading price of the CDS and you have mark-to-market collateral (you do, right?) so they have a real presence in your life. But those things don't live in the CDS. The CDS contract is just a thing that does nothing until there's a default, and then it does something.

But it's also a general-purpose creditworthiness measure, which causes some people to go around asking things like "does an S&P downgrade trigger CDS?" No. Just no. No. In theory, a downgrade might cause CDS to trade wider,* but it doesn't trigger a CDS payout. Because CDS triggers on a credit event which is a specific legally defined set of things in the ISDA definitions. Those things get to about four pages in the definitions but in brief they include "one or more of Bankruptcy, Failure to Pay, Obligation Acceleration, Obligation Default, Repudiation/Moratorium or Restructuring," and you can bet that Capital Letters means it's defined elsewhere and not just, like, your opinion about what a "Repudiation" sounds like to you.

Now. Here is a rough outline of some relevant things about Greece:
(1) At the start of our story, Greece had a bunch of bonds outstanding. Let's call these bonds Type A bonds.
(2) Greece has said it plans to do a voluntary exchange, backed up by a collective action clause, saying that in exchange for existing Type A bonds you get some package of Type B (for Bad) bonds where the only important thing to know about Type B bonds is that they have a much lower face value than Type A bonds.
(3) Greece passed a law implementing collective action clauses in its Type A bonds, which, incidentally, S&P thinks is a default.**
(4) Greece exchanged some bonds held by the ECB and other official creditors for new bonds, call them Type C. An important thing about Type C bonds is that they have the same principal amount and other terms as the Type A bonds exchanged for them. Another important thing about the Type C bonds is that they won't be subject to the collective action clause or the exchange into Type B (for Bad).
(5) There will be a voluntary exchange of Type A for Type B bonds, along with a vote on the CAC.
(6) If the vote succeeds, then everyone with Type A bonds who didn't exchange will be forced to exchange for Type B bonds.
(7) Every private creditor will have Type B bonds, which suck, while the ECB et al. will have Type C bonds, which ... suck less.

At some point in this change there will be a credit event under ISDA. Wait isn't that an unknowable mystery? No. Here is (part of) "Restructuring" in the ISDA definitions:

"Restructuring" means that, ... any one or more of the following events occurs in a form that binds all holders of such Obligation, is agreed between the Reference Entity or a Governmental Authority and a sufficient number of holders of such Obligation to bind all holders of the Obligation or is announced (or otherwise decreed) by a Reference Entity or a Governmental Authority in a form that binds all holders of such Obligation, and such event is not expressly provided for under the terms of such Obligation in effect as of the later of the Trade Date and the date as of which such Obligation is issued or incurred:
(i) a reduction in the rate or amount of interest payable or the amount of scheduled interest accruals;
(ii) a reduction in the amount of principal or premium payable at maturity or at scheduled redemption dates; ...
(iv) a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation; or [etc .]

That's long but you can read it with your heart and mind and realize that with probability one the collective action clause poofing the Greek bonds into smaller, crappier Greek bonds in a way "that binds all holders" of the (Type A) Greek bonds will be a Restructuring. Which will be a Credit Event. Which will trigger CDS.

So there is absolutely no doubt whatsoever that if Greece's plan goes off as planned then at some point between now and step (7) you will have a credit event. Which step? Well, probably (6). Some people seem to think it's (4), though, and they've asked ISDA about it, and not in a dopes calling ISDA up frequently enough to get a FAQ written way, but in a investors formally submitting a request for determination that ISDA accepted today. Here's the question:

Does the announcement of the passage by the Greek parliament of legislation that approves the implementation of an exchange offer and vote providing for collective action clauses (“CACs”) that impose a “haircut amounting to 53.5%” (MINFIN Announcement, 2.21.2012) that “shall bind the entirety of the Bondholders [of eligible instruments]” (First Article, Section 9), constitute a Restructuring Credit Event in accordance with Section 4.7 of the 2003 ISDA Credit Derivatives Definitions (as amended by the 2009 ISDA Credit Derivatives Determinations Committees, Auction Settlement and Restructuring Supplement to the 2003 ISDA Credit Derivatives Definitions, published on July 14, 2009) because (i) the European Central Bank and National Central Banks benefitted from “a change in the ranking in priority of payment” as a result of the Hellenic Republic exclusively offering them the ability to exchange out of their “eligible instruments” prior to the exchange and implementation of the CACs, thereby effectively “causing the Subordination” of all remaining holders of eligible instruments, and (ii) this announcement results directly or indirectly from a deterioration in the creditworthiness or financial condition of the Hellenic Republic?

No, right? Here is "Subordination" in the ISDA definitions:

"Subordination" means, with respect to an obligation (the "Subordinated Obligation") and another obligation of the Reference Entity to which such obligation is being compared (the "Senior Obligation"), a contractual, trust or similar arrangement providing that (i) upon the liquidation, dissolution, reorganization or winding up of the Reference Entity, claims of the holders of the Senior Obligation will be satisfied prior to the claims of the holders of the Subordinated Obligation or (ii) the holders of the Subordinated Obligation will not be entitled to receive or retain payments in respect of their claims against the Reference Entity at any time that the Reference Entity is in payment arrears or is otherwise in default under the Senior Obligation.

Now, of course, if the holders of Type A bonds now vote for an exchange into a smaller amount of Type B bonds and that is binding on every Type A holder but not Type C holders, then I guess the Type C holders end up getting their claims satisfied in advance of Type A/B holders and so there's at least a subordinationy-looking thing going on. In other words, if the entire exchange happens as planned then private creditors will be screwed, and also and upsettingly for them they will be screwed more than official creditors and so that's, like, an extra reason to be annoyed beyond the basic screwing.

But that's not the same as being subordinated contractually now. Now all that's happened is that there are two different sets of bonds with two different sets of voting rights, which nobody really thinks equals subordination.***

The determination request has supporting documentation which is mostly news articles which should tell you something, but anyway here's what S&P had to say about the ECB's exchange of Type A bonds for Type C (non-collective-action) bonds:

We have not taken rating actions on eurozone sovereign issuers following the ECB's debt swap. We believe that the swap has, at least in this instance, changed the ECB's status from implicit super-senior creditor to an explicit one.

Well. The swap has just plain not changed the ECB's status from implicit super-senior creditor to an explicit one. (You can tell because the new bonds don't say things like "Super Senior Bonds," which they would if it was, y'know, explicit.) It's changed it from "implicit super-senior creditor" to "implicitly super-senior creditor who is implicitly going to be changed into an explicit super-senior creditor in the near future, we're all pretty sure."

So, yeah, in the near future, CDS will trigger. That's why it's trading like ... well, the Journalsays "a 95% to 100% cumulative probability of default over the next five years" but I'm going to guess that 95/100 delta is more about timing and recovery than probability. (And: over the next five years?) Of course if you're a CDS holder you would like to get your payout sooner, for reasons which include (1) time value of money and (2) squicky stuff about manipulation of auctions, maybe.

But it strikes me as a little counterproductive to submit this somewhat silly determination request now based on ECB exchanges and CAC legislation and other debatable things rather than submitting a request in like three weeks based on "hey, I had $100 face amount of 2013 bonds, now through no action of my own I have like $47 of 2042 bonds, WTF?," when you know with 100% probability that a credit event has occurred. If you ignore all the noise about "OMG what will happen to the CDS, will anyone think of the CDS???" then you'll notice that the sovereign CDS market is working exactly as it's supposed to. That is: (1) when an unambiguous credit event happens, it will pay out, and (2) until then, it will trade based on the likelihood - now basically 100% - of that eventually happening. This attempt to jump-start the payout by a few weeks, at the expense of that rather clean and unambiguous process, creates exactly the sort of doubt and hand-wringing about the sovereign CDS functionality that you'd think holders would want to avoid.

Focus Turns Now to Greek CDS Payouts [WSJ]
Greece’s default gets messier [Felix Salmon / Reuters]
Isda decides to decide on Greek credit event [FTAV]

* If your theory includes a hypothesis like "ratings are a leading indicator of creditworthiness and anticipate CDS rather than the other way around." Which is possible, I guess.

** Remember: S&P declaring a default is not the same as ISDA doing it. For reasons! S&P is, like, in theory running a business of telling people how creditworthy stuff is, and when stuff is all "I have plans to evade my debts," well, that makes it less creditworthy. ISDA is just not in that business. It's in the business of determining payouts in zero-sum derivative contracts.

*** One nerdy thing: the Greek CAC will apply to the entire stock of Type A debt, not issue by issue. Many CACs work issue by issue. If "Issue X is not subject to a CAC vote by Issue Y holders" was sufficient to make Issue Y subordinated to Issue X, then everything issued by those issuers would be subordinated to everything else. But that is, really roughly, the claim here.

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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:

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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.