The International Swaps & Derivatives Association decided on March 1st that no Credit Default Swaps would be paid out in relation to Greece's Private Sector Involvement (PSI) exchange, as currently proposed. This announcement adds little clarity to the post-March 8th environment, when a deadline for voluntary participation in a nearly 75% NPV write-down for Greek bondholders will have expired. Will Greek CDS eventually be triggered? That question hinges on the use of a new mechanism for forcing hold-out investors to participate in the PSI.
Passed last week by the Greek Parliament, so-called Collective Action Clauses (CACs) would be used in the event that less than 95% of private sector holders of Greek debt agree voluntarily to the write-down. The use of CACs would almost certainly trigger CDS pay-outs associated with Greek bonds. Here we'll examine the chances of an actual CDS pay-out and the long-run consequences if such a CDS trigger were not to occur (which we believe is more likely to happen than the market currently seems to think).
As it stands currently, the Greeks are targeting a 95% participating rate in the PSI write-down program. According to BNP Paribas, that percentage seems to be a weighted average of Greece's two classes of bonds: those under Greek securities law and a smaller notional amount issued under UK law. The Greeks plan to use the CACs, if necessary, to affect 100% participation from those bonds under Greek law. The bonds issued under UK law already have CAC clauses in the indentures, albeit weaker than those recently passed by the Greek Parliament. In effect, 100% participation from Greek-law bonds would allow PSI participation in the international bonds to fall as low as 40%, a number which may still be ambitious.
Achieving 100% participation from bonds under Greek law will almost certainly require the use of the CACs. It is possible that many holders of the GGBs maturing in March may believe that hold-outs will be rewarded by slowing the process down and forcing a stop-gap repayment (possibly funded in part by the Troika) in March. Additionally, some holders of size may be planning to use lawsuits to pursue an amount substantially closer to face value than that offered under the PSI. The most likely scenario is that bondholders who are also long CDS hold out in order to force the use of CACs ( and thus, the trigger of CDS pay-outs). As stated above, it seems unreasonable to expect much, if any, participation from investors who own bonds issued under UK law because of the weaknesses of the embedded CACs in those securities. Goldman's co-head of FI wrote on the 28th that a 95% participation rate was possible, though less than likely. We tend to think that Goldman may be a bit optimistic on this point. Nevertheless, it is important to recognize the counter-currents to non-participation. It is likely that European banks who were significant CDS writers are scrambling behind the scenes to find as many bonds as possible to include in the PSI.
If the PSI fails to achieve the 95% voluntary participation threshold, what are the options? Thus far, Greek leaders have used a combination of vague threats and ominous insinuations in an effort to intimidate hedge funds and other likely hold-outs. We think it's important to recognize the Eurocrat paradigm that any-means-necessary should be used to avoid a default by an EMU member. Having worked for close to three years to avert a disorderly default by Greece, it is unlikely that the failure of a contextually minor hurdle would cause Merkel, Sarkozy, Juncker, et al to substantially reverse course.
The easy answer to a participation threshold failure is the use of the CACs. Simple, right? We would suggest that other courses of action may be more likely. Another key element of the Eurocrat paradigm, the fear of market volatility and uncertainty cannot be underestimated. The credit default swap has been the boogeyman for EU leaders from the beginning of this crisis. If ISDA indicates that the use of CACs will force CDS pay-outs, we believe that the Troika will pursue other options in order to finish the PSI write-down without the help of CACs.
The use of CACs will force European banks who have written CDS contracts to pay up. After repeated efforts to improve capital levels at institutions like UniCredit, Intesa SanPaolo, and Societe Generale it would be strange for the Troika to make a decision which could significantly impact the stability of those same banks. Additionally, a CDS pay-out would reward the hated speculators who have caused the Eurozone crisis in the minds of many leaders.
Some leaders have even voiced concerns that a CAC-activated CDS trigger could further encourage the use of CDS contracts as a speculative tool against other Eurozone debtors. The idea that actions in the Greek situation could contribute to contagion in other EMU countries has been a significant influence on Eurocrat decision-making. Given these arguments, it is less than likely an ISDA "technical default" will be allowed to occur.
One alternative is to simply pay out the par value to the non-participants in the exchange. This would be difficult to swallow for the Troika, mainly because it may have many of the same undesirable effects as a CDS trigger, though it shouldn't hurt large banks. Instead, we think the most likely option is that the Troika agrees to include either Protected Entity Debt or the previously issued Troika bailout debt in the write-down in order to achieve the desired Debt/GDP number.
Protected Entity debt are the securities held at the ECB that have been recently issued to national central banks and other protected entities in exchange for normal GGBs. Protected Entity debt is meant to protect the so-called protected entities against CACs and other dirty things aimed only at the private sector. The other option, less likely because of the loss of face involved, would be to simply write-down the Troika loans issued as part of the previous Greek bailout. Peter Tchir of TF Market Advisors has backed out the value of the Protected Entity debt at around €56b based and the amount of Troika debt is €76b.
If Greece can avoid using the CACs and ISDA does not force CDS sellers to pay out, there is a significant chance that the market's attitude towards European sovereign CDS could undergo a seismic shift. Regardless of your opinion on the likelihood of the eurozone being forced to offer further assistance to Portugal, Ireland, et al, reasonable observers can acknowledge that the inevitable priority in any of any case will be the avoidance of CDS pay-outs.
In other words, even though the owner of a CDS contract is owed protection against default, default will never occur in the European voluntary restructuring paradigm where Eurocrats are committed to making the value of all CDS 0. The effect of this policy could mean a broad reduction in demand for credit default swaps. Speculators will realize that CDS lack any intrinsic value. How can a CDS have any value when a write-down of 75% of the NPV of debtor's obligations doesn't cause the seller to pay protection? Citi's Willem Buiter addressed this concern back in October of last year:
It is possible that some exceedingly clever lawyers and PR specialist could convince the relevant Determinations Committee of ISDA that a 50% or 60% haircut need not indicate a credit event, but, were this to occur, it would probably do more damage to the EU sovereign debt and CDS market than would have occurred had a credit event been declared and CDS triggered. The reason is that a failure to trigger CDS when, according to common sense, economic logic and commercial rationality, CDS ought to be triggered, would impair the value of CDS as an asset class.
Unfortunately, we think it is very possible that the Troika accidentally destabilizes the system in a manner which makes them appear to be fighting speculation and shark investors.
At this point, the market has not begun to question the legitimacy of sovereign CDS. Evidenced by a spike to record highs of 76 bps (up-front cost of insuring $1 of Greek bonds for 5 years) in Greek CDS, investors still consider the risk of a Greek CDS pay-out significant. In fact, it appears that hedge funds and other private investors are making a last ditch effort to force a CDS trigger event. If one believes that the Troika is unlikely to use CACs that force a mass CDS trigger, you should also consider the long-term systemic effects that will have throughout the European CDS market. Potential trades are selling Portuguese, Irish, Spanish, or Italian CDS.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.