Greek CDS continues its Icarusian journey, reaching another record on Thursday.
Meanwhile, its CDS curve remains inverted — indicating that the market thinks there’s a higher risk the country will default in the short-term, than in the long-term. Other CDS curves continue to flatten, with Portugal in particular, on the verge of inversion:
You can see more of those market expectations in the below table, courtesy of BNP Paribas, and showing market-implied default probabilites for a few of the European peripherals:
What the market seems to be saying, then, is that if Greece makes it through the next 12 months, it will probably be alright for the next 48.
But given the recent moves in CDS it’s still worth asking what would actually trigger a CDS pay-out?
In BNP Paribas’ opinion just one of four possible Greek outcomes would do so with any certainty, though a restructuring of the companies debt *could* do so as well.
Here’s what they say:
Scenario 1: [Fiscal] Adjustment. Greece’s CDS would not be triggered and an orderly adjustment, as described above, would result in eventual tightening of CDS spreads.
Scenario 2: Financial support. We believe that a CDS trigger would be extremely remote under this scenario. It is in theory possible for the financial support plan to come with restrictions on it that would trigger CDS. However, a bailout plan that would require Greece to default on its sovereign debt through deferral of payments on debt obligations (thereby triggering the Failure to Pay credit event) would risk the exact contagion and negative reaction that we believe the EU wants to avoid. As an analogy, in the context of approving state aid for banks, to date the EU has not required deferral of payments due on debt obligations when not already permitted by the terms of such obligations.
Scenario 3: Restructuring. Under this scenario, whether a Restructuring credit even be triggered or not would depend on how the restructuring of debt is carried out. For a credit event to be triggered, the Greek government would have to: (1) reduce the rate or amount of interest payable on a sovereign bond; (2) reduce the amount of principal payable at maturity on a sovereign bond; (3) postpone a principal payment due on a sovereign bond; (4) subordinate the sovereign bond; or (5) change the currency of a sovereign bond – in each case in circumstances directly or indirectly resulting from a deterioration in the creditworthiness or financial condition of the sovereign.
Note that an offer by Greece to sovereign bondholders that would result in the exchange of one bond for another with reduced interest, principal, extended maturity etc, should not trigger Restructuring. This is because the terms of the Restructuring CDS credit event require an amendment to the original obligation and not a replacement of the original debt obligation for a new one.
On the other hand, if Greece renegotiated to amend the terms of its debt so as to result in any one of the consequences listed above, and 100% of the holders of any such restructured debt obligation of over $10mn were bound (whether voluntarily or involuntarily), the possibility of a Restructuring credit event would loom ahead. Any amendment affecting less than 100% of the holders of the amended obligation would not trigger a CDS credit event.
If the government were to pass legislation to require all sovereign debtholders to accept amended terms so as to result in any one of the consequences listed above, this could also result in a Restructuring credit event; provided that we could make the argument that it was due to a deterioration in the creditworthiness or financial condition of the sovereign.
Scenario 4: Disorderly default. Although we believe this unlikely, any straight default by Greece on sovereign debt could trigger the Greece sovereign CDS in a number of different ways. (1) A failure to make a coupon or principal payment when due and past the expiration of a grace period (generally longer for coupon payments and shorter for principal payments) would trigger a straight Failure to Pay credit event. (2) A Moratorium on sovereign debt declared by the government with eventual non-payment would result in the credit event of Repudiation/Moratorium or Failure to Pay. (3) In the extreme case of Greece dropping out of the EMU, if it also chose to redenominate its sovereign bonds from euro back to its local currency, this could trigger a Restructuring credit event.
In all CDS default scenarios, due to the new structure of the CDS market, any question surrounding a default by Greece would have to be raised to the EMEA Determinations Committee composed of 10 sell-side members and 5 buy-side members for deliberation and vote with an eventual auction to be held to settle outstanding CDS contracts.
The gross notional amount of CDS outstanding on Greece has rapidly increased over the past year, from something like $40bn to nearly $80bn, according to BNP Paribas.
But the net notional amount has barely increased:
According to BNP Paribas, this indicates that:
. . . that most of the new positions added by brokers and investors largely square up. As such, the maximum amount of cash that would have to change hands in case of a credit event (assuming 0% recovery and no collateral exchange before the credit event – both conservative assumptions) would be less than €9bn. This number is a couple of orders of magnitude smaller than the amount of Greek government debt outstanding – about €300bn. In other words, CDS-related losses will be small relative to direct GGB losses and other secondary effects for banks.
So bonds, not CDS, remain the real problem.
Related links:
Who’s selling Greek CDS? - FT Alphaville
Grεεk dεbt disastεr – FT Alphaville