CDS on Greece. Will it, won’t it? Trigger, that is.
The idea that sovereign CDS on the Hellenic Republic might not fulfill its promised mandate has made many headlines of late. The basic idea is that a Greek debt restructuring might be designed in such a way that it explicitly doesn’t trigger CDS on Hellenic bonds. Why would the authorities do that? Because they’re keen to avoid contagion effect and, more importantly, they really really really hate CDS.
Anyway — Barclays Capital have a blockbuster note out on Friday detailing why and how CDS could end up triggering. The key, they say, is really the prevailing attitudes of European regulatory authorities.
First, though, the debt dynamics. They’re clearly unsustainable, according to BarCap. And with much of the debt held by public entities like the EU and IMF, they reckon, private debt would need to be chopped by two-thirds to achieve an “unambiguously solvent” position for Greece.
Now there’s a distinction to be made here — reprofiling versus rescheduling. A forced debt restructuring seems to imply a reduction in the cash flows of bonds (NPV) which means any bank holding them would likely have to take losses under current accounting rules. A voluntary soft ‘reprofiling,’ meanwhile, might involve extending the maturity of the bonds without really damaging their NPV value.
So with the distinction in mind, here’s BarCap’s base case scenario — a near-term reprofiling that won’t trigger CDS and then a hard restructuring that will:
On this topic, we believe a key question that many CDS holders have been asking is how much pressure should be expected not to have a CDS trigger? In the context of the current environment, we do believe that the contagion risk remains a critical issue. While the direct economic impacts of a Greece CDS trigger would likely be quite manageable given the relatively small (USD~5-6bn) net notional exposure, we believe the risk of a significant negative feedback loop developing in other susceptible peripheral sovereign names is more significant, and, perhaps more importantly, we believe this risk is perceived by the European political community as more significant as well. As such, we would expect Greece and the broader EU to want to avoid outcomes that sound or look like a “default”. We would thus attribute a relatively lower likelihood to near-term CDS triggers.
That said, while there are clearly approaches that do not trigger CDS, we note that most of the obvious coercive approaches involving changing the net payments (net of tax) to international investors would appear to trigger CDS. Thus, the key question then becomes, how willing are Greece and the EU to live with a significant amount of international investor holdouts/‘freeriders’ without any monetary penalties? We expect the tolerance to be low, again given the magnitude of haircuts required. Thus, if and when Greece pursues a more fulsome restructuring, we would attribute a high likelihood to a CDS trigger at that point. While we imagine creative structuring and utilization of law changes could generate some ways around triggering, even based on changing net payments to international investors, we would be surprised if such a non-obvious approach were ultimately used.
The CDS market saved, perhaps, since the only thing regulators hate more than scurvy CDS speculators is …. non-cooperative banks. That said, there are still plenty of questions hovering around the swaps.
In particular, settlement and deliverability issues. Readers will recall plenty of basis trades on Greece — that is, arbitraging the (negative) difference between the CDS and bond spreads. But the strategy is predicated on being able to deliver bonds, in the event of a credit event, into the CDS contract at par.
What if it didn’t happen as planned? Here’s BarCap again:
Once a potential credit event has occurred, the question will be raised to the relevant ISDA Determinations Committee (‘DC’). Note that in order to declare a credit event, both the occurrence of the event and publicly available information (‘PAI’) that confirm the event are necessary. Assuming the DC is able to declare an event, the DC will then typically arrange to hold an auction to settle CDS (auctions are mandatory for reference entities with > 300 trades; names with fewer trades outstanding could be left to physically settle). It has historically required at least ~2 weeks from the date of a credit event to hold an auction. Post such an auction, participants who trade bonds in the auction also have up to 30 business days (in Europe) to physically settle the trades. It is also worth noting that: [things like notional amount -- the amount of CDS into which a bond can be delivered is pased on the 'Due and Payable Amount' as of the delivery date ... And that CDS recovery rates in auctions and physical settlement is based on the expected price of the cheapest to deliver bonds at the time of delivery] Given all of the above, there is a tail risk that in a restructuring, particularly one where either notionals are reduced or currencies are changed, there could be a basis between CDS recovery and bond recovery.
In other words, the value of the basis package could end up being less than par. It could also end up being positive — especially for holdouts who did not have the restructured bonds as deliverables.
Anyway, the point is that CDS in a Greek restructuring or reprofiling remains a squirrely subject.
Unsuprisingly, BarCap are recommending investors be wary of “taking a strong CDS recovery view,” and should “tread carefully with respect to cash/CDS basis trades” given “CDS tail risk.”
Related links:
Par-don me, what was that about Greek CDS? – FT Alphaville
Avoiding Greek credit event questions CDS value - Chris Whittall, IFR
ESM panic! Subordination, restructuring, CDS, oh my! - FT Alphaville