Here’s the smart thing in the eurozone plan unveiled last week.
Whatever it does for Greece’s debt sustainability (little) and to ensure private sector involvement (nothing) it really sticks a knife, so to speak, into holders of CDS on Greek debt. That, we’d argue, is something that European politicians have been gunning for for some time.
Isda effectively has no choice but to avoid calling a credit event in Greece given, as Reuters blogger Felix Salmon has noted, declaring CDS pay-outs would be tantamount to handing out free money for holders of Greek bonds that have CDS and decide not to participate in the voluntary exchange.
From David Watts and Peter Petas over at CreditSights:
… another big success of the Greece plan from the EU’s perspective is that it includes private-sector participation and it does not appear to us that it would trigger a Credit Event in the sovereign CDS market. Preliminary indications from ISDA cited in the press are that the plan does not trigger CDS as an “expressly voluntary” action. The lay person may continue to get confused around what the rating agency calls a selective default and what ISDA calls a credit event under CDS contracts, but this current action is designed to lower default risk and loss-given-default exposure and to mitigate the risk of greater financial contagion across sovereigns and bank systems. That is vastly more important than what the ratings oligopoly things of the action — as much as various EU leaders foolishly seemed determined to make the rating agencies a more critical linchpin in this restructuring.
The fact that the deal is not a credit event greatly undermines the efficacy of sovereign CDS as a speculative tool, one of the EU’s stated goals. (Note that it also undermines the efficacy of sovereign CDS as a legitimate hedging tool, but the EU doesn’t seem particularly fussed about this.) If the market comes to the conclusion that speculating in sovereign CDS is worthless (or worth less), it should reduce the number of funds willing to bet against the stressed sovereigns, which given the transmission to bond pricing, will also reduce the contagion risks to Spain and Italy.
But take note of that reference to CDS used to hedge — because this is where the EU may have shot itself in the foot.
Certainly, the EU fired a very powerful shot across the bow of market shorts, particularly in CDS. There of course is another factor in that strategy which may come back to haunt the sovereigns and the banks in that the erosion of usefulness of sovereign CDS as a hedging tool could also drive a contraction in gross exposure (versus net) and that would mean tighter limits on cash holdings, contingent cash commitments, collateral and cross-border lending generally.
Of course, Greek exposure is effectively being farmed out to the public sector at this point, but one wonders whether that CDS uncertainty will eventually leak into places like Italy and Spain.
At which point, the EU’s shafting of a hedging tool that hitherto allowed many banks to maintain their exposure to troubled eurozone peripherals may not seem so smart.
The CDS market and Greece’s default – Felix Salmon
Greek debt talks cast doubt over sovereign CDS – FT
Par-don me, what was that about Greek CDS? – FT Alphaville
ESM panic! Subordination, restructuring, CDS, oh my! – FT Alphaville