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."
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.
(Brief interlude of "what the heck are you talking about": it seems increasingly likely to me - perhaps it was always obvious to everyone else - that when Greek CDS is finally triggered, it will pay off based on the trading price of new Greek bonds, which has absolutely no connection to the loss that you'd experience on any current Greek bond: if you have a bond with a $100 face amount and you get in exchange $5 of new bonds, and they trade at par, you get zero recovery. That's screwed up man.)
Anyway, duly chastened, I will outsource you to smarter people for your daily dose of Greek CDS, including Felix Salmon for a sensible takedown of people gibbering about ooooh no CDS hasn't been triggered yet, freak out!, Lisa Pollack for a timely reminder that much of the demand for Greek CDS historically came from banks buying CDS out of non-economic regulatory gamesmanship so in some broad sense we shouldn't really care if they get hosed on the payout, and Deus Ex Macchiato for a man who knows a thing or two about cheapest to deliver and who is unmoved by your whining:
The market chose to trade a product that hedged individual bonds less well in exchange for having a more liquid instrument. Now I am not going to take a position on whether that was a good choice or not, but I will say this. If you want a CDS that references a particular bond, and whose settlement amount is determined by the price of that bond after the credit event – or which allows you for sure to deliver a given bond – then buy one. Yes, it will cost you more than a standard CDS that is more liquid. It won’t have a readily observable price (although one might assume it would mostly trade in line with more liquid standard CDS). It will be hard to trade. But if you want a Ferrari, why are you buying a Ford?
This is wise counsel. Still I am a zero-arbitrage kind of guy. The freaky thing about the Greek situation is not that the settlement will not mirror the particular value of any particular Greek bond - it's that it might have nothing whatsoever to do with the experience of any holder of Greek debt who bought CDS before the restructuring. That's a bit obscured because the values are not that far off, but you could make them that way. Instead of giving holders $30 of bonds with 3ish% coupons that trade at $10, give them $10 face amount of bonds with 3ish% cash coupons and PIK coupons for the excess sufficient to make them trade at $10. (Exercise for the reader: demonstrate equivalence.) If you believe the smart people who think that Greek CDS will pay out based on trading levels (vs. par) of post-restructuring bonds, then you are left with no CDS payout on that construction.
You cannot quite wave that away like this:
Ian Pearce, who heads up European credit trading at RBS Capital Markets in London, ... [says]: “While there are some serious questions over CDS as a hedge, it will still exist as a spread betting tool,” he says. In other words, people will still trade CDS as a reflection of the credit worthiness of the sovereign issuer. As a borrower gets closer to default, the value of the hedge rises, offsetting the deteriorating price in its bonds. “A punting tool,” Pearce calls it.
You see a fair amount of the claim "it doesn't matter if it pays out on default as long as the value of the hedge rises as you approach default," but that is obviously wrong unless I suppose you can approach default like Zeno's turtle without ever getting there. If it doesn't pay out on default then no one will pay for it on the way there. It's a backwards induction instrument. And if the payout on a default is totally un-indexed to credit-related losses caused by the default, then you have ... a ... problem.
Unless, of course, you can wave your hands and say LOOK A TIGER and make the problem go away through confusion and accident. Our own commenter anonhfm explains:
ISDA will definitely try to sweep this under the rug, because by pure luck the likely CTD [cheapest to deliver] bond (the longest of the 20 new GGB) is trading in the w/i [when-issued] market within one point of where the w/i market for the whole package of 20 new GGBs + 1 warrant will put recovery on an old GGB. Talk about inverse Murphy's Law. They'll declare an event on March 9, when Greece invokes CACs (don't see how anybody could wiggle out of that one and not expect major legal shitshow and the end of CDS), true recovery will be 24, Auction will settle at 25, and ISDA will say, "see, it all worked out!"
So everything's fine then. The End. I SAID THE END.
* Gotcha! No, I've given up on that dream. All Greek CDS all the time. Next week we'll go paragraph by paragraph through the Credit Definitions.