Greek CDS shenanigans

| October 28, 2011 | 20 Comments

By Theophilos on Flickr

We now know that private holders of Greek bonds will be “invited” (seriously–this was the word used in the EU summit statement) to take a write-down of 50%–halving the face value of the estimated $224 billion in bonds that they hold. This will help bring the Greek debt-to-GDP ratio down from 186% in 2013 to 120% by 2020. The big question–apart from how many investors they will get to go along with this, given that they couldn’t reach their target of 90% investor participation when the write-down was only going to be 21%–is whether this will trigger a CDS pay-out.

That this is even up for discussion is mind-boggling. These credit default swaps are meant to be an insurance policy in case Greece doesn’t pay the agreed upon interest and return the full principal within the agreed timeframe. If they don’t pay out when bondholders are taking a 50% hit then what’s the point? I call shenanigans.

ISDA, the International Swaps and Derivatives Association that wrote the agreement governing most  derivatives trades, states clearly that a Credit Event would be triggered under the type of haircut proposed…but only if this haircut is forced on all bondholders. And here’s where it gets interesting.

There’s no doubt that this haircut is forced. Sure, sure, bondholders are only being “invited”. But listen to what Jean-Claude Juncker, Luxembourg prime minister and Euro Group president, had to say:

“It was the fiercely rendered wish by the people, Merkel, Sarkozy, Juncker, that if a voluntary agreement with the banks was not possible, we wouldn’t resist one second to move toward a scenario of total insolvency of Greece, which would have cost states a lot of money and which would have ruined the banks.”
-Source: Reuters

Sounds pretty coercive, no? Yet despite this it still looks like most Greek bondholders will be forced to pay for their own stupidity. ‘Cause as it turns out, over 90% of Greek debt is governed by the terms of Greek law. Which offers much less protection than the UK laws governing the remaining ~10%.

It may seem counterintuitive, but it would have been totally fine and standard practice to have more of this Greek debt covered by UK law. UK law governs a lot of financial contracts that otherwise have nothing to do with the UK because it’s simply seen as a good, solid upstanding legal framework.

Greek law, on the other hand….

What follows is a quick comparison, with thanks to Choi, Gulati and Posner of the Law School at the University of Chicago.

1. Negative pledge

  • English law-Greek bonds restrict Greece from giving more security to new borrowers without offering the same to earlier borrowers
  • Greek law-Greek bonds have no such clause

2. Pari passu

  • English law-Greek bonds say that all bondholders will be paid with equal priority in case of insolvency
  • Greek law-Greek bonds have no such clause

3. Collective Action Clause (CAC)

  • English law-Greek bonds can have changes imposed on all bondholders, if a majority agrees
  • Greek law-Greek bonds have no such clause

4. Cross-default 

  • English law-Greek bonds will have accelerated repayment if Greece defaults on any bond it has issued, whatsoever
  • Greek law-Greek bonds–well, you guessed it.

As you can see the English-law bonds give much more protection to bondholders than the Greek-law bonds. Not to mention the simple fact that Greek politicians can always change Greek law to get the outcome that they want. But it’s difference #3, Collective Action, that really explains why the Greek CDS will likely not be triggered. If Greek law-Greek bonds had a CAC and a majority of bondholders agreed to the 50% write-down then all bondholders would be forced to go along. That’s the type of legalistic coercion required to trigger the CDS; the threats from Merkozy & Co. don’t really count.

That’s not to say that this issue is closed. A decision to not pay the CDS out under these circumstances could do serious damage, anyway. The ISDA Determinations Committee will have the final word but will only weigh in if a market participant requests a ruling. And I do believe that somebody, somewhere is gonna request a ruling. The vote that wins an 80% majority of the Determinations Committee’s members will carry the day. So who’s on this mighty committee that has the power to affect the worth of hundreds of billions of dollars in investments, move global markets and make the leaders of 27 countries tremble like a dried leaf in a hurricane? From ISDA’s website:

You really could not make this stuff up. I’ll just leave you with these thoughts from a Reuters story earlier this year (emphasis mine):

Although there is no formal obligation, there are supposed to be Chinese Walls between the people sitting on the DC and traders that know the firm’s position on a given name. There still is, however, concern from some industry members that these Chinese Walls are not always respected in practice.

“Some people are certainly concerned they’re being manipulated by the dealers,” said one derivatives lawyer. “On technical points, the DC is fine. The problem is for larger decisions like Greece, where people are clearly going to vote their own self-interest. It’s not a perfect mechanism for big issues that affect a large amount of people to be decided by a small portion of the overall market.”


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Category: Eurozone