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CDS Market Almost Ready For Another Greek Default

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Last week ISDA, who are in charge of credit default swaps, circulated some proposed changes to CDS to account for all the Greek, Argentine, SNS, everything unpleasantness. This prompted me to try out my one journalistic technique - calling1 ISDA and asking them to send me a copy - but they declined, so we'll just rely on this research note from JPMorgan's Saul Doctor and Danny White. Here's the gist:2

ISDA will publish a list of “Package Observable Bonds” (POBs) based on size, liquidity, maturity and governing law. The proposals suggest that there could be one domestic and one international law bond in each of the following silos – a) 1-3 years, b) 3-12 years, c) 12-30 years – based on a set of rules that determine the largest and most frequently traded bond in each silo. An initial POB will remain as such unless, prior to the Credit Event, it no longer meets the deliverability criteria, is called/matures, or is reduced below a threshold. New bonds would be added when a particular bucket is empty.

If a Credit Event occurs (Restructuring or other Credit Event) and a POB has been restructured into a package, then that package, in its entirety, will be deliverable into the auction. For example if a POB with a notional of $100m is written down by 50% and the remaining portion converted into 50 shares, then the 50 shares could be delivered against $100m of CDS. If there is more than one package on offer, then the one that has the highest subscribers will be chosen. All obligations meeting the deliverability criteria remain deliverable as long as they were issued prior to the Credit Event.

So lots of people have been calling for this for a long time - me least of all, but also real people like the Managed Funds Association and Darrell Duffie. But you get a sense from that summary of how it's more complicated than dopes like me think.

The basic weirdness of CDS is that it lets the protection buyer deliver any bond of the issuer to the protection seller, in exchange for the par amount.3 In some abstract sense this lets you buy $100mm of generic CDS to "insure" $100mm of any bond or bonds of the issuer that you like, without having your "insurance" match your bonds, which promotes greater liquidity and price discovery and usefulness in CDS. Concretely, though, it gives investors a cheapest-to-deliver option that can be quite valuable: in a straight-up bankruptcy a $100 30-year 2% bond might be worth as much, as a bankruptcy claim, as a $100 1-year 5% bond, but in most flavors of restructuring the 30-year will be worth much less. So an investor who is long the 1-year bond, hedged with CDS, may end up with a windfall by settling the CDS against the 30-year.

But that's life. My simplistic expectation would be that:

  • Issuer has 26 bonds, Bond A through Bond Z.
  • CDS on a payment default would settle by reference to the cheapest-to-deliver bond, say Bond Q.
  • If the issuer restructures its bonds, then Bond A is restructured into Package A, Bond B into Package B, etc.
  • CDS on a post-restructuring credit event would settle into the cheapest-to-deliver package, maybe Package Q or maybe some other Package - Package R say - because the packages change the relative values.

But that's not what ISDA does: they use the "Package Observable Bonds" definition to limit the potential packages to just Packages, like, A through F. And they do that before the restructuring even happens: you pick Bonds A through F as the POBs, because they're the most liquid, and then on any restructuring they're the package you look to.

The point of this, I suppose, is to limit the opportunities for investors and issuers to restructure into windfalls at the expense of CDS writers? You could imagine a variety of games otherwise, all of them more or less predicated on really really screwing one set of bonds so as to improve the CDS payoffs of holders of all the bonds. Hypothetically, a hedged holder of Bonds A through Z might prefer a restructuring that pays 60 cents on the dollar in restructured value to Bonds A through Y, and one cent to Bond Z, over a package that pays 70 cents to all of the bonds. (Because the hedged package in the first deal is worth 60 + 99 = 159 cents on the dollar for Package A, 159 cents for Package B, ... 1 + 99 = 100 cents on the dollar for Package Z; while the second deal is worth 70 + 30 = 100 cents on the dollar for each bond.) To some extent that's inherent in the cheapest-to-deliver concept, but you can understand why dealers and ISDA would be worried about adding opportunities for gamesmanship. Especially gamesmanship that would essentially allow sovereigns to pay bondholders with CDS writers' money.

It's not clear what the next steps are: as JPMorgan write, "Exactly how the new proposals are implemented – through a market wide protocol, or as a change to future trading standards – is still to be decided." Strangely, too, these reforms apply only to sovereign CDS.4 The MFA and Duffie proposals were also sovereign-only, and I suppose there's good reason to leave it at that. Corporates don't have the same ability as sovereigns to poof bonds into different bonds or things wholly other than bonds. (Corporate bonds, for instance, tend not to have collective action clauses that allow principal write-down or subordination/equityification of principal: if a corporate tried to do to you what Greece did to its bondholders, you'd just say no, and hang on to bonds that will either pay off at par or get an appropriate CDS payoff.) Corporates seem to cause fewer really knotty CDS headaches than sovereigns.

But not none! We've talked about SNS Reaal, the Dutch baank that was naationalized and whose subordinaated bonds were poofed into "nothing" or "claims" or "bonds, but you can't have them." Lisa Pollaack has a post today about SNS's CDS, which is a mess: basically, the sub bonds' CDS won't get paid off, because you can't deliver the sub bonds into the CDS auction, because the Dutch government has locked them up or evaporated them or whatever your preferred metaphor is. And ISDA's proposals, even if they were enacted tomorrow, would seem to do nothing for those sub bondholders. The modern, sovereign-flavored forms of credit defaults extend beyond just sovereign defaults, and continue to be a headache for CDS.

ISDA to Send Credit-Default Swaps Changes to Traders [WSJ]
Proposed CDS Revamp: ISDA proposes changes to the CDS Documentation [JPM]
One hundred and one pains in the SNS for the CDS market [FTAV]


2.This exchange-property issue is the most interesting one to me. There are three other things being addressed: broadening the scope of Qualifying Guarantees that allow an obligation to be delivered into CDS to align with the cash market, amending successor provisions to capture the case where "Company A moves all debt to Company B and ceases to exist" and no one notices for 90 days (which sounds funny but happened to UnityMedia), and standardizing reference obligations so that all CDS on one Reference Entity will have a single Standard Reference Obligation.

3.Really CDS is cash settled by auctions, but I like to pretend that the old-timey physical settlement mechanics get you to the same place. That might be true. In any case they're easier to visualize.

4.As Doctor and White note:

Given the changing nature of Corporate and Financial debt instruments, we expect to see further proposed changes to the current Definitions, particularly with respect to Financial CDS and upcoming EU bail-in regime.


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.