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Greece’s impending default (and what it means for CDS)

Published by marco on

It’s not that Greece’s financial situation is complex. It’s that the common explanation for Greece’s troubles—that the Greeks as a people are lazy—is not only incorrect—per capita, the average Greek works more than the corresponding famously sedulous German—but deliberately racist and unhelpful.

Greece is currently running a larger deficit because of state-incurred debts. These debts are due not to exorbitant expenditure on a hopelessly top-heavy and overgenerous social apparatus—as common wisdom would have us believe—but are instead due to a revenue problem: Greece has a serious problem in collecting income taxes. And the problem is primarily with collecting income taxes from the wealthiest corporations and people.

The obvious solution is to collect more taxes. This is not always easy and, in Greece’s case, is met with especially strong resistance—resistance which is supported by various other interested parties, like some EU countries, which are simultaneously putting pressure on Greece to cut services and implement “austerity measures”.

If they can’t create more revenue, then the way that sovereign nations fix this problem is to print more money. This injects more liquidity into the economy and simultaneously allows an economy to grow its way out of its poor debt ratio. Greece, however, cannot do this because it has no control over its currency. The other main problem is that Greece’s local inflation is higher than that of the nations to which it owes the most money. But Germany is not willing to move its inflation rate much higher than 1–2% and Greece will never get its rate down from the current 4–5% to anything below Germany’s. Greece is stuck in the Euro and can’t make any moves of its own.

Since this is not a particularly easy problem to solve, and since the obvious solution involves making those in power pay more of their income taxes, the EU decided to ignore the revenue problem and instead focus on outlays. Hence the focus on lazy Greeks who are bleeding their country dry with their demands for social safety nets and pension plans and other benefits extraneous to a good life.

The EU imposed austerity measures on Greece as a condition of the aid packages that they hoped would kick-start the Greek economy. In effect, they gave the Greeks a bunch of money, then told them they could only spend it on paying outside creditors—a gift for private investors but in no possible way a plan that could lead to growth in Greece. The EU economists touted these plans as economically viable and called from every hilltop that massive growth could be expected now that Greece had finally learned to tighten its belt. England, by the way, embarked on exactly the same mission.

Neither one of them succeeded, as was expected by anyone with their head screwed on straight and anyone whose job did not depend on them thinking otherwise. Low or negative growth in both countries for the last few years has not quelled the call for more austerity measures, but that proves more the endurance of the zealot than the worthiness of the idea.

So Greece failed to grow, it still doesn’t know how to collect taxes or revenue, it has an even smaller social net now and more people are out of work and years have been wasted. Now what?

Well, for starters, the Greeks are finally going to default on at least some debts. They have, to date, paid punctually and in full on all claims but will, starting in March, have to default. Their other choice is to get the hell out of the Euro and re-introduce the Drachma. This is a more drastic decision, but would likely be better for Greece in the medium- to long-term.

But what of this default? How is it going to work? What are the terms? Will it trigger a default event that will force those nasty CDS (Credit Default Swaps) to be paid? The articles Greece’s default gets messier by Felix Salmon (Reuters) and Understanding Greece’s default by Felix Salmon (Reuters) provide many of the answers.

Broadly—and most of this post is dealing with quite broad explanations—existing Greek bonds will be replaced with bonds in two categories, which will be redistributed to current investors who choose to partake in the restructuring—and beyond a certain percentage of those investors, all investors will have to partake or end up holding worthless old bonds. Bonds in the first category will be worth about $0.10 on the dollar and bonds in the second about $0.15, leaving about the 75% haircut that is being bandied about these days.

The gory details are below (as provided by Mr Salmon):

“But then there’s the CDS holders. In the best-case scenario for Greece and Europe and bondholders, every €1,000 of old Greek bonds will get converted to new bonds with a face value of just €315. Those bonds will probably trade at about 30% of face value, which means the new-Greek-bond component of the exchange will be worth about 10 cents for every dollar in face value of old Greek bonds that you might currently hold. Add in another 15 cents of EFSF bonds, and the total value of the exchange will be about 25 cents on the dollar, which is why people are talking about a 75% “present value haircut”.”

To add a twist, the bonds held by the ECB (European Central Bank) are exempt from the haircut, because it’s the ECB that’s been funding the soft landing in the first place, so it’s assumed that they’ve absorbed enough losses at this point and the remaining losses can be absorbed by private investors.

“[…] the two events together have effectively cleaved the stock of Greek bonds into two parts, with one part (the bonds owned by the ECB) being effectively senior to the other part (the bonds owned by everybody else). This is known as Subordination, and Subordination is a credit event under ISDA rules.”

On the other hand, it’s not all investors who will carry the extra burden: the EIB (European Investment Bank) will also be proud owners of full-value bonds. This includes the UK, which hasn’t pumped any money in Greece’s direction, so will garner protection from losses that it hasn’t in any way actually paid for.

If a 75%-haircut doesn’t signify a default event, it’s hard to imagine what could. But whether the world will consider this a default is still being debated as significant parties think it would be too horrible to allow a European nation to do something as gauche as default and others don’t want to risk showing the CDS market to be utter hogwash. As it is, the CDS market is being treated very badly and it’s hard to see how anyone who purchased CDS before Greece started to slide significantly—when the imminent default was not priced in—could think this is in any way a proper way for the market to behave. Those investors are in possession of liquidity vehicles that they viewed as a pure investment but which are now threatening to actually be used as promised. And the scary thing for those investors is that the ostensible guarantee provided by a CDS is turning out not to be much of a guarantee at all under real-world conditions.

Come to think of it, it’s certainly not the first of many fanciful financial ideas that have shattered into a million worthless pieces upon introduction to reality (see: the end of 2008).

Obligations are being shuffled around to suit the most powerful and the needs of nations and investors with what they thought were clear terms and conditions on their investments are finding that they may, in actuality, never be paid. This is no longer unpredictability, which is bad enough for investment, but an almost certainty of a bad investment, which means the CDS market may dry up (at least in the case of sovereign nation debts). It’s hard to explain in short, but How Greece’s default could kill the sovereign CDS market by Felix Salmon (Reuters) does a good job.

“The way that CDS auctions are meant to work is that once a borrower defaults on its debt, that defaulted debt continues to be traded in the market, and its value then determines the amount that credit default swaps need to pay out. But in this case, Greece’s defaulted debt might well not continue to be traded in the market. In which case, when traders need to find a cheapest-to-deliver bond to bid on in the CDS auction, they’re going to have to use one of the new bonds, rather than one of the old ones.

“And now you can see why the nominal price of the new Greek bonds is so important. Right now, it seems that they’ll be trading at a nominal price of about 30 cents on the dollar, which is close (ish) to the current market price of the old Greek debt. But there’s no particular reason why that should be the case. If Greece had gone for an 85% nominal haircut rather than a 68.5% nominal haircut, then the nominal price of the new Greek bonds would be 67 cents on the dollar — and anybody who wrote credit protection on Greece would only have to pay out 33 cents on the dollar rather than 70 cents on the dollar.

“In other words, Greece’s CDS really aren’t protecting holders of Greek bonds at all — or if they do, it’s more a matter of luck than of law. When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds. (Emphasis added.)”

A CDS on existing Greek debt will be worth whatever the technocrats who build the conditions of the structured default decide it will be worth. This is not a pleasant position to be in, as an investor (unless one has undue influence over said technocrats and can shield the original debt from any haircut at all, as in the case of the EIB). How all CDS are at risk of not paying out by Felix Salmon (Reuters) follows up on the topic of CDS: whereas the article above makes clear that the payout on a CDS on sovereign debt for which the event has triggered is subject to manipulation, it turns out that all CDS are subject to manipulation.

“If you own protection on a credit, then, you’re very much in a world of caveat emptor. You can trade in and out of CDS and make a good living; these things are, first and foremost, trading vehicles. That’s why they’re more liquid than bonds. But if you have a strategy which involves actually getting paid out on your CDS in the event of default, then you should definitely worry that the payout might not happen, even if the event of default is clear and declared. What’s more, there’s really no good way to hedge that risk.”

There are some who will rejoice that the CDS market may be hearing its death-knell (though rumors of its death are likely exaggerated) but there is nothing a priori wrong with CDS: it’s that the market for these derivatives was completely unregulated and ballooned into a significant part of the world economy, to a size that would tear down a much larger part of said economy were a significant default ever to occur.

This is not in any way going to be easy for Greece, but it will be survivable and then other countries with similar debt-to-GDP loads will start to seriously consider it.

“if the Greek bond exchange goes really smoothly, and the sun rises in the morning and Italian bond yields stay below 5%, then maybe that’s the most worrying outcome of all. Because at that point Greece will have managed to wipe out, at a stroke, debt amounting to some 54% of GDP. You can see how Portugal and Ireland might be a little jealous.”