Why did Gretchen Morgenson write that column on Sunday about Greek credit default swaps? The answer is that the irresistible lure of writing about CDS lured her into the very murky waters of the Greek basis trade — the trade where you own Greek bonds and then hedge them by buying credit protection on Greece. Now this trade is emphatically not a big deal even in the context of the Greek debt restructuring: it’s probably a couple of billion euros in total, and won’t make much difference either way. But the outcome of the trade is likely to set an important precedent for the sovereign CDS market more generally, so it’s worth looking in a bit of detail at exactly what’s going on here.
Basis trades belong to a set which is relatively common in financial markets: things which are meant to be very safe but which, in fact, aren’t. Merrill Lynch reportedly lost somewhere in the region of $15 billion on basis trades, and at the height of the crisis I proposed that the US government should step in and start buying bond-and-CDS packages as a way to make money and get a bit of price discovery and liquidity into the fixed-income markets.
In theory, basis trades are simple: you buy a bond, which either pays off in full or doesn’t. If it does, you’re golden. If it doesn’t, then any losses you make on the bond can be recouped by profits on the CDS. So long as you buy the bond at a higher spread than the cost of credit protection, you should be guaranteed a modest profit.
But the question is how do you get there from here. Because CDS are derivatives, they’re subject to margin calls, and if you can’t meet CDS margin calls, you might be forced to unwind your trade before maturity. And that can be very expensive, if the basis has widened and markets have moved against you. So while the US government can play the basis trade without worries, everybody else has to treat it with a certain amount of caution.
And all of that was true before various EU member governments started deciding, in a killing-the-messsenger kind of way, that there was something profoundly evil about the sovereign CDS market and that they wanted to start trying to ban it.
There are two main forces putting the Greek restructuring together: the Greeks, and the EU. The Greeks, frankly, don’t care about CDS; what they care about is their debt, and their debt-service payments, both now and in the future. The CDS market, like all derivatives markets, is a zero-sum game, and whether CDS get triggered or not makes little substantive difference as far as Greece is concerned. That’s why I was highly skeptical of the idea that BNP had a conflict of interest when it was working for the Greek government while sitting on a key CDS committee: the Greek government really doesn’t have a dog in this fight.
The EU, on the other hand, has quite a lot of politicians and technocrats who hate the sovereign CDS market and would love to see it die. Bonds can be illiquid; CDS are the market’s way of pricing sovereign debt as accurately as it can. And when sovereign spreads are spiking nastily, it’s easy to blame a relatively small number of CDS traders for scaring the market, exacerbating very real problems, and making it harder to persuade people that things aren’t actually all that bad.
So, if the EU wants to throw a wrench of some kind into the spokes of the CDS market, what could it do in Greece? One thing would be to simply encourage Greece to do a “voluntary” bond exchange which doesn’t trigger the CDS. If bondholders playing the basis trade end up taking a 50% haircut on their bonds but getting nothing from their CDS, then clearly the CDS hasn’t provided them with the protection they thought it would.
There’s been a significant drop in the net notional amount of Greek CDS outstanding, of late, and that might indeed be a function of people unwinding their CDS trades in the face of uncertainty as to how they’ll be treated. But here’s the good news, as far as the CDS market is concerned: as the unwind has been going on, Greek CDS have continued to trade at extremely elevated levels. On a mark-to-market basis, anybody in the basis trade is fine. If they bought protection quite cheaply, they can unwind that trade and sell it at a high price, which will give them profits to offset against any losses they are forced to take on their bonds. In that sense, it doesn’t really matter what happens after the exchange: the trade is over, and it’s done what it was designed to do. More or less.
Meanwhile, as the unwind has been going on, the size of the Greek CDS market has been shrinking, so the number of people affected by the final decision as to whether or not the CDS is triggered has also been shrinking. That could be seen as good news for the EU and for people wanting to kill off the CDS market — but there’s a case to be made that the basis traders have simply moved on to Italy instead, which isn’t really a net improvement.
And the EU doesn’t just want to shrink the sovereign CDS market, it would ideally like to harm it in some way, in the hope that, once burned, the CDS traders stay away altogether next time.
Which brings me to the threats that BNP’s Belle Yang reportedly made in conversations with bondholders. Gretchen Morgenson didn’t explain them very well, partly because — I’m told — Yang herself was a little bit incoherent in what she was saying. But one bondholder did explain to me what he took away from the meeting.
The thing to remember here is that if the CDS isn’t triggered in the bond exchange, it doesn’t just disappear in a puff of uselessness. It still exists, and it still protects bondholders from a payment default. If you hold the old bonds — if you haven’t tendered into the exchange — then in many ways your basis trade hasn’t changed. Either Greece continues to make the coupon payments on the old bonds, or else it doesn’t, at which point the CDS really should trigger and make you whole.
But there are two ways that the sovereign CDS market really could be damaged in the aftermath of an exchange. The first is if the untendered old bonds got impaired significantly while the CDS remained untriggered. For instance, let’s say that Greece, using its own domestic law as the instrument, changed the payment terms on the old bonds so that they were paying out only a fraction of what they were paying before the exchange. That would almost certainly be a credit event under the ISDA definitions, and would trigger the CDS. But under one reading of what Yang was saying, Greece and/or the EU might attempt to impair the old bonds and pressure ISDA to declare that the impairment doesn’t count as an event of default. I very much doubt that ISDA would ever make such a determination. But if it did, then that would be a serious blow to the sovereign CDS market.
The second possibility is that Greece continues paying the old bond coupons in full, alongside its new bond coupons. And the Greek CDS market continues trading without any credit event. Until, one day, Greece being Greece, the country defaults again — on both its old bonds and its new ones. At that point, the CDS triggers. And to collect your payment on your CDS, you need to give up your bonds. But here’s the cunning bit: Yang has been hinting, I’m told, in her meetings with bondholders, that the EU and/or Greece will find some kind of way to change the law so that the old bonds aren’t eligible to be deliverable into the CDS exchange — to get paid out on your CDS, you’ll need to pay for new bonds, and your old bonds will be worthless.
If this were a credible threat, it would certainly be a good reason, at the margin, to tender into the current exchange rather than hold out. I don’t think it is a credible threat, but it’s easy to see how some investors might not want to take the risk.
The thing is, CDS is a young market, which hasn’t been tested in lots of different circumstances. No one can know for sure how it’s going to play out in future. So far, the CDS market has held up pretty well — everybody prophesying doom in the wake of the Lehman bankruptcy, for instance, was proved wrong. And when CDS were triggered on Fannie and Freddie despite the fact that there was never any payment default, the market coped with that well, too. My guess is that CDS will do what they’re meant to do, in Greece. But BNP is trying to spread a certain amount of fear, uncertainty and doubt over whether that’s necessarily the case.
As a result, anybody in the Greece basis trade needs to have a good degree of self-confidence that they know what they’re doing. Which, frankly, they should have had all along. Using derivatives to arbitrage securities is always a little bit messy and fraught with legal risks. If you don’t have confidence in what you’re doing, you shouldn’t be doing it in the first place.