Wednesday, February 1, 2012

ISDA on Greek Default Definition

You ask the ISDA what their definition of a Greek default is (if a 70% haircut is not a default!)?
Well, that depends on what your definition of "is" is.

From the ISDA, with commentary:

A CDS is triggered when a Credit Event occurs. There are three Credit Events that are typically used for Western European Sovereigns (including Greece), they are: Failure to Pay; Repudiation/Moratorium and Restructuring. We will focus on Restructuring for these purposes.
The Restructuring Credit Event is triggered if one of a defined list of events occurs, with respect to a debt obligation such as a bond or a loan, as a result of a decline in creditworthiness or financial condition of the reference entity. The listed events are: reduction in the rate of interest or amount of principal payable (which would include a “haircut”); deferral of payment of interest or principal (which would include an extension of maturity of an outstanding obligation); subordination of the obligation; and change in the currency of payment to a currency that is not legal tender in a G7 country or a AAA-rated OECD country. The decline in creditworthiness or financial condition requirement is intended to filter out restructurings that occur as a result of improved financial condition.
Are CDS triggered by a declaration by a rating agency that the Reference
Entity has been downgraded or is in “default”?
No. There is no link between a rating agency declaration and a CDS Credit Event. It is possible that the same set of facts might give rise to both, but it is also possible that one might occur but not the other.
As noted above, one element of the Restructuring Credit Event is that the event has to occur as a direct or indirect result of a decline in creditworthiness or financial condition of the reference entity. In determining whether that criterion has been met, rating agency actions may -- but need not -- be considered, together with any other relevant information.

Would a debt exchange trigger a Credit Event?

A voluntary debt exchange typically would not trigger a Credit Event.  A restructuring credit event requires an amendment of terms of outstanding bonds or loans, whereas an exchange means the original bonds are redeemed and replaced with new bonds on the new terms.  Economically they may be the same but legally they are different, which could have very different consequences for CDS.

Go back and read that last part again.  So if the old worthless bonds are replaced with new yet equally worthless bonds, it is not a credit event, i.e. no default.  LOL.

Next, the ISDA is prepared for everyone who thinks through the logical conclusion of the fact that all of their OTC hedging is in fact worthless when nothing will ever be allowed to be considered a default, and the ISDA attempts to convince investors otherwise that this logical conclusion is incorrect:

If Greece’s debt were restructured in a way that did not trigger a Credit Event,
would this call into question the utility of CDS as a hedging tool?

No. It has always been understood that the Restructuring definition cannot catch all possible events. Restructuring was, in fact, dropped as a Credit Event for North American investment grade names because it was felt to be unnecessary. It was, however, maintained in Europe because European companies tend to restructure their debt where North American companies would reorganise under Chapter 11 (which would trigger the Bankruptcy Credit Event). If a creditor is hedging using CDS, and declines to participate in a voluntary restructuring, then the creditor would still hold its original debt claim and its CDS hedge, which would continue to protect against future non-payment or a mandatory restructuring for the remaining term of the CDS.

Next, the ISDA informs investors that when it comes to CDS, their word IS THE LAW:

What is the process for determining a Credit Event?
All firms entering into CDS transactions using the standard ISDA documentation (described above) have agreed to be bound by the decisions reached through the process for determining a Credit Event set out in the CDS Definitions. This process is fair, transparent and well tested, and was developed working closely with global regulators. Credit Events are determined by one of five regional ISDA Credit Derivatives Determinations Committees (DCs). An event with respect to Greece would be dealt with by the EMEA DC. The composition of the DCs is explained below.

And finally, the ISDA attempts to convince investors that a Greek default really is no big deal anyways, as the CDS contracts net out to a measley $3.7 Billion. 

Would a Credit Event on Greece lead to massive payments by protection

No. According to the Depository Trust & Clearing Corporation’s CDS data warehouse, the total net exposure of market participants who have sold CDS credit protection on Greek sovereign debt is approximately $3.7bn as of 10-21- 2011. This figure is calculated by summing the net exposures of the protection sellers, and so it is impossible for any one firm selling protection to have more than $3.7bn in exposure and, of course, given that there are many net sellers, any one seller’s exposure is likely to be far less.

Of course, the ISDA hopes you never listened to The Doc's interview with Jim Willie last week, where Willie discussed the fallacy of this argument that the counter parties for these derivatives net out:

'We hear constantly about the counter parties for the derivatives that these banks own. And we hear that they offset. Like Bank A has credit derivatives for default of Bank B and vice versa, so they’re both ok, they cancel out. Well that’s DEAD WRONG! DEAD WRONG!! THEY BOTH DIE! They don’t help each other! It’s like saying well this guy’s drowning in a pool in the deep water, and so is his friend! Neither one can swim, but it’ll cancel them out, and they’ll both be ok. THAT’S A BUNCH OF GARBAGE!! The counter party risk is MUTUAL AND DEADLY!'