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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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.**

The new numbers are perhaps a little dicey - I see CMA showing Greek CDS offered at at like 77-78, more in line with the 79 haircut than the 83 payout I get above - but whatever. At this point everything is within the margin of error (by which I mean the margin of bid/ask and/or the margin of nobody really wanting to hear your tale of woe or glee about how you got 99 or 104 for a package designed to pay out par) so I suppose this little sideshow is over.

But Let's Think About What This Means. Or, I mean, not really, but let me tell you an imaginary story.

There's a theory about "empty creditors" which runs that bondholders who hold $100 of a distressed company's bonds and $100 of CDS against those bonds have no incentive to reach a socially value-maximizing voluntary restructuring that avoids bankruptcy, because they get par in bankruptcy and less than par in a restructuring, and that's Bad. Here is some evidence, and some other evidence. Others disagree, but I have to say Greece seems confirmatory: there are some people who want to Do The Right Thing for the debtor, and some people who want to hold out so they get par, and those people are jerks but in the minority here - but maybe not everywhere.

We've talked before about how coercive restructurings can be designed to really really screw hedged bondholders. Again, it looks like whatever happens in Greece will be within margins of error, but you could have designed a restructuring with the same economic results for bondholders but where all the new bonds trade at "par," making CDS payouts zero. Greece seems to have reached rough justice by accident and/or the goodness of its heart.

The thing is, though, it's a two-way market, and those gray market numbers are a reminder that you could also structure things to really really benefit hedged bondholders (and screw CDS writers). Greece, for instance, could have offered the same package but instead of GDP warrants it could have thrown in a new hundred-year bond with a zero interest rate. If that bond trades at, I dunno, 1 cent on the dollar, then it's the cheapest to deliver and so sets the CDS price.*** Specifically a 99 recovery, instead of the 75-85 that we're looking at. Giving hedged holders an all-in recovery of something like 120, rather than 99-104.

In a restructuring more or less negotiated between European governments (which want to preserve their banks) and European banks (which want to preserve themselves), that would not happen. But in a restructuring negotiated between, say, a smaller European company**** and a few big bondholders who were hedged, you could imagine working a windfall: "we'll vote for a principal-reducing collective-action-claused forced restructuring if you'll give us some way-below-par bonds in the restructuring to goose our CDS payouts." So like you could exchange 100 of old 5-year bonds for 60 of new 5-year par bonds and 10 of new zero-coupon 100-year bonds which are worth 1 cent on the dollar. Giving creditors a recovery of 70 on the bonds and 99 on their CDS, for 169 total. And that surplus is maybe good for those companies and those creditors, who can split the surplus. Which surplus is provided by the big dealer banks who net write single-name CDS, who will be less happy.

I speculated groundlessly that maybe the CDS delivery thing would get fixed now that people see that it's broken; but the answer appears to be nope, not really. There are various kludgy fixes that might by accident fix this problem, and Greece appears to have alighted on one of the subtler ones, which is to just have the numbers line up by accident. But it sounds like if this problem resulted in banks paying out less than a "fair" amount on their CDS, ISDA would not be rushing to fix it.

If, on the other hand, all this publicity led to some corporate restructurings where banks paid out way more than the "fair" amount ...

* Though I can't really let this go unpunished. Apparently European 5-year nominal risk-free rates are below zero?

** WTF? aside. The idea here is that if as seems likely the Greek CDS auction runs after the exchange, then recovery on CDS is based not on what your package of bonds was worth before Greece, y'know, defaulted, but rather on what the cheapest-to-deliver new Greek bond is worth. That appears to be the 2042 bond allegedly trading at 15/17. So CDS pays out par (100) minus recovery (call it 17, the offer price of that new bond), or 83. And your package - which consists of a slice of 2042 bond, slices of various other shorter-dated new Greek bonds, some cash-like short-dated EFSF bonds, GDP warrants, and a good healthy amount of nothing (i.e. principal reduction) - is worth 21, or a 79 cent haircut. Which your CDS recovery more than makes up for. On these facts. If instead the Greek CDS auction runs before the exchange, or was based not on the new bonds but on the package received for old bonds, then I guess you'd deliver the cheapest to deliver of the old bonds and things would sort of work out - but it looks like that's not what happens under the rules. Though, I mean, what do you make of this?

*** I'm sure I'm being very juvenile about the interaction of cheapest-to-deliver and auctions. Sorry!

**** Because apparently there's no Restructuring in the US, who knew.

Related

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.

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.

This Is Really Only The "Second" Greek Bailout?

If you're into Greece you've probably already read all about it and if you're not I can't make you. But in brief: Greece is fixed and we will NEVER HEAR ABOUT ANY PROBLEMS EVER AGAIN. In less brief: (1) Some folks stayed up all night and produced a statement. (2) Greece's private creditors will be offered the long-anticipated opportunity to voluntarily exchange their old bonds for new bonds, which will for the most part be the same as the old bonds except for minor differences including but not limited to a greatly extended maturity (to 2042), a 53.5% reduced face amount, and a 3.6% blended interest rate. (3) If they don't voluntarily exchange, which they will because - hilariously - they've already taken accounting writedowns (and also because I guess it's better than a disorderly default), private holders will get CAC'ed, which may or may not be as bad as it sounds, but in any case at least CDS will pay out, unless it doesn't. (4) Also the public sector will do various helpful, confusing things. (5) In exchange for this, Greece will enact horrible austerity, and because no one believes that Greece will actually do that, there will be escrow accounts and what Reuters ominously calls "permanent surveillance by an increased European presence on the ground." (6) Everyone is pretty sure we'll be doing this again in six months and, look, just fair warning, I will not be writing about it then, because feh. We haven't had a serious international bankruptcy, which this pretty much is, since I started paying attention to the financial markets, two months ago, so I mostly think about insolvency from a US bankruptcy law perspective. One thing that happens in bankruptcy is that, like, really really roughly speaking, the creditors stop being creditors and become the owners. This isn't always the case but the basic playbook of US bankruptcy law is: