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The saga that is the Greek CDS trigger – a credit event being ruled only after CACs were inserted retroactively and then used by the Greek government to force the debt swap – made me think of a classic scene in the "Princess Bride." Watch the YouTube clip of Billy Crystal as Miracle Max, who famously states that Wesley is only ‘mostly dead’:

It just so happens that your friend here is only MOSTLY dead. There’s a big difference between mostly dead and all dead. Mostly dead is slightly alive. With all dead, well, with all dead there’s usually only one thing you can do….Go through his clothes and look for loose change.

In the context of the Greece CDS market, CDS were triggered only after Greek bonds were deemed ‘all dead.’ Going forward, will CDS insurers pay only when a bond is declared ‘all dead,’ rather than being ‘mostly dead’? This does to some extent discredit the viability of CDS as a hedge. Bill Gross agrees, as reported by the FT, stating that the sanctity of the contracts have been challenged.

Historical data on gross CDS notional support Bill Gross’ views.

The chart above illustrates the percentage change in gross notional CDS contracts written (or bought) over the last year – 3/4/2011 to 3/2/2012 (see Table below for full representation of European sovereign CDS market characteristics). The data are from the DTCC and available free to the public. I use Table 6 and include those sovereign credits listed by regional characteristic ”Europe”. I chose gross rather than netted CDS exposure, as I view gross to be an appropriate proxy for the aggregate trend in market sentiment for CDS.

Some notable observations:

  1. Over the last year, the largest declines in gross CDS exposure occurred in markets insuring bonds issued by Portugal, Greece, Iceland and Ireland. The largest increase in gross CDS exposure occurred in markets insuring bonds issued by Belgium, Slovenia, France and Denmark.
  2. Of the top four gross notional declines, three countries are currently EU/ECB/IMF (Troika) program countries: Portugal, Greece, and Ireland. I surmise that the reduction gross CDS exposure in these markets is related to a loss in market confidence for CDS as a viable hedg.
  3. Iceland is an interesting case. I deduce that the reason for the decline in gross CDS exposure on Iceland’s bonds is not related to a loss in confidence of CDS as a hedge, rather improving credit fundamentals. In February, Fitch upgraded Iceland’s credit rating to investment grade.
  4. Italy and Spain saw an increase in CDS notional exposure over the last year, +7.7% and +2.3%, respectively. I expect that markets are cognizant of the fact that Spain and Italy are just too large for Troika to manage via PSI (private sector involvement). Therefore, CDS may still be deemed a viable hedge for Spanish and Italian bond exposure. Of note, the netted CDS exposure declined, indicating that some banks may not be hedging contracts written (see Table below).
  5. The vast majority of European CDS markets saw an increase in gross notional exposure. This is likely related to rising debt levels more broadly.

Triggering Greek CDS only after the use of CACs is the equivalent of declaring Greek bonds ‘all dead’ – beforehand, they were only ‘mostly dead.’ Evidence demonstrates that markets are wary of this distinction between ‘mostly dead’ and ‘all dead’ and may reduce further CDS exposure the smaller markets where Troika interference is possible.

As a reference, the table below illustrates the full set of data available in DTCC Deriv/SERV Table 6. Cells highlighted in green indicate reduction in gross and net CDS exposure over the last year.

(Click charts to expand)

Source: CDS: Insurers Pay Only When The Bond Is 'All Dead'