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.
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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 the emphasized part of this is not what you'd call, in the strictest sense of the term, "true":

If anything, the deal has cemented the view that private investors are second-class when it comes to sovereign debt deals and that credit default swaps offer little protection. This will make it very hard for private investors to trust European sovereign debt, setting the stage for further messy bailouts in other troubled European countries. ... Investors who chose to hedge their sovereign debt risk with credit default swaps won't be collecting any cash given the way the deal was structured.

But you could have a tiny drop of sympathy for the rest of it. We've spent much of the last four months or so hearing that the Troika is trying to prevent Greek CDS from paying out. Felix Salmon thinks that the politicians' desire to avoid a CDS trigger is caused by epistemology, and I am always willing to listen to some epistemology:

A lot of otherwise very well-informed people still think that this bailout is like previous bailouts, designed to avert a default. When in fact a huge default is right at its very heart. When the CDS get triggered, it’s going to be very obvious that this is indeed a Greek default. That’s something which bond market professionals are acutely aware of, but it hasn’t really sunk in to the broader popular consciousness.

If the Greeks and the Europeans can structure a deal where the credit default swaps aren’t triggered and the bondholders voluntarily swap their old bonds for new bonds, then it’s actually possible that this misunderstanding could continue well past the bond exchange, to the point that the broad public thinks that we’ve just seen another bailout, and misses the footnote that the bailout was accompanied by the single largest bond default in the history of the world.

But I suspect that the world consists mostly of (1) people who get that Greece is defaulting in a very real not-paying-their-debts sense, and understand at some level things like CDS credit events, and (2) people who don't, and don't. So avoiding a CDS trigger so that people in category (2) won't notice that there's been a default seems like a bit of a stretch.

Which leaves you with the other things. Two possible other goals might be "protect CDS writers" and "harm CDS buyers." If your assumption is that CDS writers are for the most part European banks, then a CDS payout need not Bring Down The Entire Global Financial System for European politicians to be solicitous of those banks' economic interests. (And just because you've taken a pretty harsh mark already doesn't mean you wouldn't enjoy reversing it. Accounting isn't destiny, even for banks.)

Similarly, if your assumption is that CDS buyers are mostly eeeeeevil hedge funds then, well, we know quite clearly how European politicians feel about evil speculative hedge funds betting against European credit. They don't like them. They try to make them go away.

In the abstract it sure does look like private investors are screwed by a deal that squishes private bondholders while sort-of protecting the seniority of official creditors, imposes a retroactive collective action clause, and casts CDS into some doubt for a while and then ends up triggering it but in an annoying way with some possible slippage. But it's important to disaggregate "private investors," and also not to disaggregate too much what's gone on in Europe over the last few months. The creditors that Europe likes - the ECB and national central banks of course, but also big European banks who do a lot of lending to Eurozone governments and who those governments wish would lend them more - make out okay. The official creditors get some seniority; the banks get - well, they get a Troika that fights for their honor a bit on CDS triggering, and more importantly they get oceans of cheap funding from the ECB. All in all the wages of playing along with the official sector look pretty pretty good. Why not buy Italian government bonds? What could possibly go wrong?

The hedge funds who get dragged CAC'ing and screaming into this voluntary exchange, and whose CDS is called into question over and over again, are probably annoyed and maybe they will take their ball and go home and never lend to a European government ever again. I sort of doubt that personally; memories are weirdly short and price makes up for a lot. But you could also easily imagine that a decent portion of Europe would be fine with it: the theoretical arguments for more liquid and deeper markets run up against a visceral distaste for particular kinds of market participants, and the distaste wins. (So: unilateral transaction taxes!)

And that's ... actually not that strange. I used to work with companies issuing equity thingies, and I've described that process here before as a coldly economic determination of a market clearing price. But it's not really, or not entirely. Companies all the time fiddle with the allocation of their securities offerings, even at the cost of maximizing price, because they like some sorts of investors and dislike others. Often the ones they dislike are the same ones France dislikes: hedge funds, arbitrageurs, short sellers, high-frequency traders, etc. Better to give something on price and get stable supportive long-term on-side investors than to price to the last basis point and get an investor base of angry hedge funds.

I'm broadly sympathetic to claims of the form "Europe is screwing private investors and that sets a bad precedent for the future since no one will buy European government debt." (Though of course you have to take those claims in a context of Greece not having any money: someone kind of has to be screwed, and it's just a debate about the mechanics of that.) But this is not really that. Rather, the Greece bailout roughly speaking optimizes who gets what to encourage the long-only, bank-style investors to come back for more - and to discourage the speculative hedge funds from doing so. That really should, in expectation, drive up the cost of financing other shaky European governments. That just may be a price they're willing to pay.

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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.

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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.**

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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: