Why Are Greek Credit Event Swaps Still In The Mid 60’S?

As we wait for more IIF announcements about the Greek Private Sector Involvement (PSI), Greek CDS remains bid above 60 points up front.  For a contract that is about to be “worthless”, this seems to have a lot of value.

Why would Greek CDS still be so well bid?

One answer is stubbornness and stupidity.  Maybe the CDS buyers are so convinced that Greece is a mess, that they will bid up CDS in spite of all the efforts by the “authorities” to circumvent a Credit Event. Maybe some buyers really think they are buying Credit DEFAULT Swaps, rather than the Credit EVENT swaps that they are actually buying?  In spite of the name, it is not a Credit Default Swap, it is a Credit Event Swap. It is the Credit Event definitions that trigger the contract, and in spite of popular opinion, the word “voluntary” does not appear anywhere in the ISDA definitions.

Neither of those explanations seems satisfactory, although I do think the misunderstanding about what triggers a CDS may play a role.  What other explanations are there?

What notional of bonds is really represented by the IIF negotiating team? Of the 200 billion or so of bonds outstanding, how many are truly represented by the IIF?  When later today, or tomorrow, Dallara announces an agreement in principle, how many bonds are committed to that deal?  I think there is a real risk that the amount of bonds that are actually part of this negotiation is fairly small.  We may be disappointed to find out that only a fraction of potential bonds are being obligated to follow the IIF’s deal.  You would think after all the failing in PSI, they would have ensured that the vast majority of bonds are committed to whatever this IIF led group decides to do, but so little has been done like a “proper deal” that it wouldn’t be a shock to find that the IIF and EU have overestimated how many bonds will agree to the deal they agree to.

Even if the IIF deal represents close to 100% of bonds, the CDS could still have value.  In many ways, that is truly scary, but here is why the CDS could still have value.

There will be some holdouts.  The deal will not receive 100% agreement (of that, I’m 100% certain).  These holdouts are most likely to be “evil speculators”.  That will create a big issue for Greece.  Will they pay these holdouts out at par?  What a horrible message to send, pay holdouts at par after reducing notionals by 50% for participants.  But if they don’t want to pay them and reward them for holding out, it is hard to see how they can “screw” them without a default – either failure to pay or some retroactive Collective Action Clause (both of which would be a Credit Event).  The Net Notional of Hellenic Republic CDS outstanding is only around 3 billion (less than 1% of the debt outstanding).  After the PSI deal is done, the amount of debt would be reduced, but a default on a relatively small amount of holdout debt ($10 million I believe), would cause a Credit Event for the entire amount of CDS outstanding.

Away from the “holdout” scenario is the problem that the deal doesn’t ensure Greece doesn’t need to renegotiate again in the future.  Remember the goal of this is to get debt to GDP to 120% by 2020!!!  120% debt to GDP ratio isn’t exactly pristine, and how much can go wrong between now and 2020?  The new debt would be under UK law, so it would be much harder to force another “voluntary” restructuring without triggering a Credit Event.  The documentation of the new bonds will make it harder for Greece and EU to force through a similar deal in an attempt to once again circumvent triggering a Credit Event.  60 points up front seems like a lot to pay if they really are going to reduce debt dramatically, but the fact that debt will remain high and the new bond covenants will give creditors more power going forward does mean CDS isn’t worthless.

There is one last thing that makes Greek CDS retain value.  All of the conversations have focused on actual Greek debt.  What about debt guaranteed by Greece?  How much debt of weak Greek banks has Greece guaranteed?  These aren’t going away or being reduced and the banks they have guaranteed aren’t improving anytime soon.  It is hard to account for these guarantees, but they remain outstanding and if are called on and not met, would also be a Credit Event.  This is a second order effect, but shouldn’t be ignored since the Greek banks have been using Greek Government guarantees as a means of accessing the ECB or Greek Central Bank.

Finally, what else could be going on?  One of the original 4 PSI proposals was a commitment to roll into new bonds when old bonds mature. This is very different from an immediate exchange.  If someone holds 100 million of bonds due in a year and agrees to the exchange (restructuring, haircut, default) then Greece will have reduced their debt by 50 million.  If all they do is agree to exchange when their bonds become due, there is no immediate reduction in Greek debt.  I fully expect they are doing an immediate exchange, but watch the fine print as nothing about these negotiations has been straightforward or made sense from a normal deal.

The NPV reduction is another element that needs to be watched closely. The NPV hit will likely be 60% to 75%, but that is irrelevant to Greece. The Notional reduction is primarily what impacts Greece.  If the debt notional is reduced from 200 billion to 100 billion, then Greece has reduced debt by 100 billion.  It doesn’t matter if the new bonds only have a market value of 50 billion, that is the bondholders problem and doesn’t directly benefit Greece.  Greek bonds already trade at 25% of par, so the secondary market discount doesn’t provide a direct benefit to Greece.

So for Greece, the key is immediate exchange (rather than an exchange as bonds mature), and what the actual notional reduction is.

The interest rate is of secondary performance.  In the grand scheme of things, a 3% or a 5% coupon on the new bonds doesn’t make or break Greece.  The coupons seem like a great savings, but the reality is that it isn’t much different from the coupons Greece is currently paying. How “low” the coupon is and how helpful it is for Greece, needs to be compared to the average coupon Greece is currently paying and not to where bonds are trading in the secondary market.

What would be impressive?  Immediate exchange of all Greek debt with at least a 50% notional reduction, 30 year maturity, and low coupon.  Maybe we get that, but I doubt it, and it seems pretty well priced in.

Anything less is likely to disappoint the market as the realization that nothing is fixed sinks in, and that this may not even take near term “hard default” off the table (this PSI is a default no matter how it is spun even if it isn’t a Credit Event).