Schrödinger's CDS

Noble Group currently occupies a state that is neither defaulted nor non-defaulted.
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For all the talk about credit default swaps being perilously complex and troublesome, they're really pretty simple instruments. They work on the assumption that a given company at all times occupies one of two states: (a) normal, and (b) defaulted. When (a), the CDS buyer pays the CDS seller. When (b), vice versa. There are Pokemon cards with more complicated terms than this.


But what if there were some indeterminate stage between (a) and (b), between defaulted and non-defaulted? What if the International Swaps and Derivatives Association, which governs CDS and makes those default determinations, decided to go quantum-mechanical in its deliberative approach? Thanks to the ongoing self-immolation of commodities trader Noble Group, we'll soon find out:

Earlier this month the ISDA committee responsible for deciding on the status of Noble’s debt said it was unable to determine if the Singapore-listed commodity trader was in default or not, creating a vacuum that allowed bilateral claims to proliferate across the market. It is the first time ISDA has dismissed a question of default without making a ruling either way.

This is made awkward by the fact that banks and traders have some $1.2 billion in outstanding bets on Noble Group's debt. Battle lines have already formed:

Goldman Sachs, Nomura and hedge funds who stand to gain from having bought CDS protection on Noble are facing off against JPMorgan, BNP Paribas and other traders. [...] After the first claim was filed early last week, it forced a chain reaction of claims and counterclaims that spiralled through the market, with one source saying 12 institutions had triggered notices of default.

Why the dispute? A couple months ago Noble restructured its debts in an apparent effort to masochistically prolong its own suffering. Though this wasn't a default, credit default swaps don't require a default to trigger the “default” in the name “credit default swap.” Instead, CDS contracts can be invoked with so-called credit events ranging from ordinary bankruptcy to restructuring. The latter, according to the ISDA's latest definitions, includes “a postponement or other deferral of a date or dates for either the payment or accrual of interest or the payment of principal or premium.”

But somehow the ISDA committee that classifies credit events can't make a decision on whether Noble postponing a loan payment qualifies as Noble postponing a loan payment. From the ISDA Credit Determinations Committee, which was formed after 2008 in order to facilitate smoother CDS resolutions:

The AEJ DC considers that it currently does not have sufficient information that is public or that can be made public to determine the Restructuring Credit Event DC Question one way or the other, in particular the AEJ DC has not been able to obtain the underlying documentation in respect of the Borrowing Base Facility (and amendments thereto) and Noble’s guarantee in respect thereof (the Relevant Documentation).

This probably isn't what you, a seasoned CDS investor with hundreds of millions in outstanding CDS bets, want to hear. If anyone should have the relevant documentation related to whether a company has defaulted or not, it should probably be the international consortium devoted to determining whether companies are defaulted.

For clues as to why there's some gridlock amidst the committee, which has kept Goldman and Nomura at loggerheads with JPMorgan and BNP Paribas, maybe we should have a look at who it is that makes up the committee:

Bank of America N.A.
Barclays Bank plc
BNP Paribas
Citibank, N.A.
Credit Suisse International
Deutsche Bank AG
Goldman Sachs International
JPMorgan Chase Bank, N.A.
Mizuho Securities Co., Ltd.
Societe Generale

Are we suggesting that certain members of the vaunted International Swaps and Derivatives Association Credit Derivatives Asia Except Japan Determination Committee are letting conflicts of interest interfere with their contractual obligations? Until the committee has a more believable explanation for its gridlock than “the dog ate my Noble Group borrowing facility documentation,” then yes, yes we are.

World’s biggest banks square off over Noble credit default swaps [FT]


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.