Since the Eurozone proposal for a 50% haircut on outstanding Greek debt was issued, many pundits have questioned the value of sovereign CDS. If the contract is not triggered by that level of haircut, they opine, then the product is somehow flawed.
We suggest the pundits first read our FAQ on the subject, and then, if they are still interested, the definition of the Restructuring credit event. A simple rule to follow is that if you are going to opine on a contract, you have to read the contract. In any event, we will leave it to our well-tested determinations committee process to decide the issue, if and when a question is presented.
We do, though, think it’s important to provide some perspective on the issue. Let’s start by considering two other credit events. The first – Bankruptcy – is a standard credit event in the corporate CDS world but not in the sovereign CDS world. It has the advantage of providing a pretty bright line, typically a bankruptcy or insolvency filing. There are other events in the definition that could trigger a bankruptcy credit event short of an actual filing. It is possible that the events that have transpired regarding Greece and Greek debt might have triggered a Bankruptcy credit event if we were dealing with a corporate. But we will never know because we are not dealing with Hellenic Republic, Ltd.
The second type of credit event – Repudiation/Moratorium – does apply to a standard sovereign CDS contract. It recognizes the particular steps that a sovereign might take to disavow obligations under its indebtedness. It involves a declaration of a sovereign’s inability or unwillingness to fulfill its outstanding obligations. That’s a serious step, with implications for the country’s economy and the sovereign’s future ability to access the international debt markets, but it is not unheard of for it to occur. Russia did it in 1998. Yet no one involved in the discussions surrounding Greece wants to touch this third rail.
Without an ability to declare bankruptcy and given the reluctance to formally repudiate indebtedness, negotiators have centered on a voluntary exchange of old debt for new, with the resulting focus on the Restructuring credit event. Yes, we know that some holders of Greek debt are between a rock and a hard place. And we know that officials have put significant pressure on banks to accept the deal. It does sound a bit like someone has made them an offer they can’t refuse.
The fact remains, though, that the exchange is not binding on all debt holders. If you don’t like the deal, don’t exchange your bonds. Hold onto them. Whether you take the deal or not, you will keep your CDS. Collect the payments on the bond as long as they are being made. If a payment is missed, trigger the CDS and be made whole. Users of these products know the drill. In fact, it could be a more economic proposition for some holders of Greek bonds.
The obsession with avoiding a credit event is, in our view, misguided. (Others agree; see this WSJ blog post.) All this to avoid settlements that we know from DTCC data will not exceed $3.7 billion in the aggregate, most of which has already been collateralized.
ISDA will certainly reflect on this experience, consult with its members and consider whether future changes to its definitions are appropriate. The sovereign CDS product will no doubt continue to evolve. Evolution, often driven by external events, is typical of any derivative product. That’s a process that we have seen time and time again. And whatever the document says in the future, we hope people will read it before they opine on it.