And Now, Spanish CDS

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Did you think you could avoid it?

So the deal is this. Spain has some banks, and those banks have some loans, and those loans have some problems. And so Spain wants to bail out its banks via a thing called the Frob, which is perhaps more confidence-inspiring in Spanish than it is in English? The Frob has the small problem of not having money, and this weekend the problem was solved by Europe - I like saying "Europe" because the actual institutions in these things always seem pretty ad hoc but in this case it means mostly the European Stability Mechanism but also the European Financial Stability Facility - promising it up to €100bn.

Now one thing about Europe is that it wants its money back, so the ESM loans will likely be senior to existing Spanish government debt. In some ways this is weird - Spain is financing a subordinated investment in the financial sector of its economy with a senior lien on all of its economy, and subordinated bailouts could both create more flexibility and give Europe upside in any recovery - but in other ways, this is the way the world works. As Zero Hedge put it, "the FROB loan is effectively a priming DIP": when you really need the money, and you can't afford to pay for it in rate, you pay for it in seniority.

This leads, theoretically, to sadness if you are a Spanish government creditor, because now you are subordinated. On the other hand, it leads, theoretically, to happiness because Spain is now funded through means other than a bond market that may shut at any moment, so it should be able to keep afloat and service its debt, including your debt, which is what you really want. Your expected recovery on default has gone down, but so has your probability of default, so there are offsetting effects. Which effect is bigger? That does not seem susceptible to an a priori answer but as of late this morning lower recovery seems to be winning:

Now, if you are a Spanish government creditor, you have probably seen something like this coming, and one thing you might have considered was buying credit default swaps on Spanish bonds because sovereign CDS always, always, always works to shift risk and eliminate uncertainty. There is $14.2bn of Spain sovereign CDS net notional outstanding, versus around $900bn of Spanish government debt. And, if you are the lucky owner of some of that CDS, you now have the opportunity to ... have a confusing argument over whether it's payable now!

The argument is:

(1) Under the ISDA definitions, a Credit Event includes a Restructuring, and a Restructuring includes "a change in the ranking in priority of payment of any Obligation, causing the Subordination of such Obligation to any other Obligation."

(2) "Subordination" means ... well:

"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. ... For purposes of determining whether Subordination exists or whether an obligation is Subordinated with respect to another obligation to which it is being compared, the existence of preferred creditors arising by operation of law or of collateral, credit support or other credit enhancement arrangements shall not be taken into account, except that, notwithstanding the foregoing, priorities arising by operation of law shall be taken into account where the Reference Entity is a Sovereign.

So if there's a contractual provision saying that the ESM gets paid first, then existing bonds have been subordinated and thus restructured.

(3) The ESM treaty provides that "ESM loans will enjoy preferred creditor status in a similar fashion to those of the IMF, while accepting preferred creditor status of the IMF over the ESM," which sounds pretty contractual, though there are potential exceptions.

(4) On the other hand, the mere possibility that at some point in the future official creditors will be favored over regular creditors, even if that possibility is backed by a lot of precedent and official creditor bargaining power, is not a subordination and thus not a trigger.

(5) The ISDA determinations committee went through a similar exercise when Ireland took a bailout from the IMF, which normally gets de facto preferred creditor status, and determined that there was no restructuring even though existing Irish bonds were effectively subordinated to the IMF.

There is a wonderful lawyer question here, which is if the IMF has de facto preferred status, and the ESM explicitly says "we will have the same preferred status as the IMF, but less of it," then does the ESM have de facto preferred status (like the IMF) and thus not trigger CDS, or does it have explicit contractual preferred status (because it, y'know, explicitly contractually says that it has the same status as the IMF) and thus trigger CDS? Joe Cotterill thinks it's contractual, though he's not exactly talking in the CDS context:

But in the months we’ve been covering this, the funny thing about the ESM’s preferred creditor status was always that the ESM Treaty makes the seniority de jure. Unlike de facto IMF loan seniority, this stuff’s been written down.

The reader who brought this to our attention takes the other view. I take no view except to hope that lots of people will file questions with ISDA and generally make a mess of this. Perhaps they will: Spain's bonds are still paying, and are not trading at super distressed levels, so you won't get an enormous recovery from triggering CDS, but if you bought CDS in sunnier times and think Spanish credit is likely to improve in the medium term, wiping out your current mark-to-market gains, then you have an incentive to try to trigger now to crystallize those gains.

Unlike in the Greece case, though, it seems like nobody in charge of the bailout cares much about these questions, or about preserving and/or punishing CDS holders. After the non-disaster of the Greek trigger, it seems much less likely that triggering or not triggering CDS at expected or unexpected times will do any systemic damage - making these more amusing questions for lawyers, and the investors who love them, than serious issues for the world financial system. And, perhaps, as the European crisis grinds on, it's getting harder and harder for anyone to put much blame on market speculators for the problems of Europe's banks and governments - making punishing them less of a crowd-pleaser than it used to be.

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