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Greek CDS Will Be Fixed Soon, In Case You Were Waiting On That

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As Greece prepares to default on its new bonds, now seems as good a time as ever to fix the problems that occurred when it defaulted on its old bonds. Remember that? Basically there was this thing where if you had a Greek bond with a face amount of €100 and CDS on that Greek bond, and that Greek bond got poofed into a new Greek bond with a face value of €20 that traded at par, then your CDS would pay out not the expected €80 that you lost on your first bond but rather €0 because the second bond was deliverable into CDS and it traded at par. Which makes no sense if you view CDS as hedging your losses on the first bond, which to a reasonable approximation you do.

Fortunately, though, in the particular case of Greece, the new bonds were split into lots of little tranches and one of them basically looked like the old bonds, value-wise (though not otherwise), and so everything worked out and actually made CDS buyers a little bit of extra money. So that was nice for them, but otherwise it was all just terrible.

So this gets a yay:

Credit-default swaps market leaders will meet this week in New York and London to discuss changes to the contracts in what may be the biggest revisions since 2009.

The International Swaps and Derivatives Association’s credit steering committee will meet May 11 to discuss changes, said Steven Kennedy, an ISDA spokesman. Possible amendments to standard contracts, which are governed by ISDA, include how debt-for-equity exchanges would be treated after a bankruptcy, specifying that credit swaps only cover losses from defaults that occur after their purchase, and clarifying how the date of a so-called credit event is determined, according to people familiar with the situation.

The solution to the Greek-exchange problem for Portugal or whoever is actually pretty simple: just revise the ISDA definitions to make clear that when it refers to Obligations it means (1) the Obligations or (2) after the Obligations are involuntarily exchanged, whatever they are involuntarily exchanged for. That is the idea proposed by these Stanford folks but don't fall over yourself in racing to congratulate them for their ingenuity because it's kind of an obvious idea. I mean, even I had it.

Don't congratulate me either, because I didn't even know it was an idea - it's just what is done in every other instrument ever so I assumed CDS had to work that way too. In derivative instruments like convertible bonds, equity options, securities lending (including of Greek bonds) - kind of everything but CDS - if the underlying security changes into something else, the derivative instrument changes into the same sort of derivative on the something else. The fact that CDS does not work that way was sort of puzzling to me and, it turns out, to ISDA and CDS market participants. But it's all better now, or will be soon.*

Back when Greek CDS was maybe not going to work, there was much discussion of the possibility that this could kill the sovereign CDS market, and specifically of the possibility that that was exactly what European leaders wanted, what with the CDS market being the province of nasty hedge funds who were speculating against their debt, driving up their borrowing costs, and generally being unsportsmanlike.**

That speculation always suffered from one small flaw, which is that in the final analysis European leaders don't get to decide how CDS pays out - ISDA does. And ISDA is a creature of banks and institutional investors and lawyers. Lots of lawyers. And so it's not surprising to see ISDA rushing to fix this payout problem, after waiting a decent amount of time so as not to make it too obvious that it was a huge embarrassing problem in the first place. First of all, in my experience derivatives bankers and traders and investors and lawyers do place some stock in just plain being right: even aside from who has what economic incentives to have CDS work or not work, if you're in the business of designing CDS you want it to work out of sheer pride of craftsmanship.

But second, ISDA - in the person, particularly, of its dealer members - wants CDS to work because it makes money trading CDS, and if the product doesn't work no one will buy it. Plus: banks buy CDS! When they have bought CDS, they want it to pay out. Plus plus: banks sell CDS! When they have sold CDS, they might prefer to have it pay out the wrong amount of that amount is too low, but they would prefer to have it pay out the right amount rather than the wrong amount if the wrong amount is too high. And the way CDS currently works, instead of the potentially too low Greek payout, CDS buyers could maneuver to get too high a payout in the next Eurozone defaulter.***

I suppose it's possible that governments might try to reduce the prevalence of various sorts of financial transactions just by introducing uncertainty and doubt into those transactions. That is one model you could have for the Volcker Rule, which "allows market-making" but requires a look into your soul to determine if you are in fact market-making. But if that's what they want, it'll have to be through their own rules, of which there are plenty. The financial industry, left to its own devices, prefers its rules predictable.

ISDA to Begin Biggest Revisions to Credit Swaps Since 2009 [Bloomberg]
Redesigning Credit Derivatives to Better Cover Sovereign Default Risk [SSRN]

* Duffie and Thukral at Stanford are specifically addressing sovereign CDS and the Greek exchange problem, but an "exchange property" concept would fix not only the Greek thing, but also a similar problem with corporate debt-for-equity exchanges like at GM, which are also on the agenda. Here, if the company does a prepack bankruptcy and poofs its bonds into equity, then there are no bonds to deliver into CDS and so the CDS never pays out. This can be fixed by just doing the auction before the bonds poof, but you may not want to rely on that always happening.

** There was also a residual sense that European banks were the net writers of Greek CDS and so preventing them from paying out would be a mitzvah from a systemic stability perspective, on the theory that European banks needed money more than hedge funds did. That theory was probably overblown but it existed, anyway.

*** Basically: €100 old Bond A exchanges into €20 face amount new Bond B trading at par plus €1 face amount new Bond C with 0.1% coupon and 100-year maturity; new Bond C trades at one cent on the dollar and is delivered into CDS, resulting in €99 payout on CDS plus the €20 new Bond B, for a package worth €119 to the holder while costing Portugal or Spain or whatever only 20-21 cents on the dollar.


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.**

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.