Satyajit Das: Default Semantics – Credit Default Swaps & Greece

Yves here. Despite the technical focus of this post, the underlying issue, of whether Greek CDS will pay out as protection buyers expected, is very important. As Das discussed in an earlier post, in the first real test of the CDS market (the Delphi bankruptcy in 2005), credit defaults swaps had required delivery of bonds to get the insurance payout on the contract . Since the volume of CDS on Delphi was over five times the amount of bonds outstanding, that would have meant a lot of people bought dud insurance. That was recognized to have the potential to have very bad outcomes for the market. So, on the fly, the International Swaps and Derivatives Association implemented “protocols” by which any two counterparties, by mutual consent, substitute cash settlement for physical delivery. In other words, they came up with a big fix that was nowhere in the contracts. Ain’t it nice to be a big financial player?

Efforts to extend Greek debt may require similar efforts at fixes, and if they aren’t fully effective, it could have a chilling effect on the CDS market (not that we think that is a bad outcome, mind you). But even with all the powers that be out to preserve the product and avoid roiling the markets, the conflicting objectives of various players may render that outcome not so easy to achieve.

By Satyajit Das, the author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming September 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)

The European Union’s linguistic gymnastics, redefining default as “restructuring” or “re-profiling” and the structure of any final deal on Greek debt has “real” implications for the arcane workings of the CDS market.

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city because of his health, to take the waters. Informed that they are in the desert, Rick ironically replies that he was “misinformed”. Investors and banks that purchased Greek sovereign credit default swap (“CDS”) to protect themselves against the risk of default may find that they have been similarly “misinformed”.

The “hedges” may not provide the protection sought. While net outstandings of Greek sovereign CDS is modest (around US$5 billion), the current imbroglio raise important questions about the role and efficacy of CDS contract generally.

Similar to credit insurance, in a CDS, the buyer of protection pays a fee to obtains indemnification against the risk of default of a borrower (Greece) and any resultant loss from a protection seller. Payment is triggered by a “credit event”, technically defined as failure to pay interest or principal, debt moratorium or repudiation or “restructuring”.

“Restructuring” is concerned with a material restructuring of an entity’s payment obligations or a forced substitution of new obligations. Generally restructuring will entail:

Changes in the ranking of the debt, reducing seniority, subordinating the obligation or converting debt into equity.

1. Change in the currency of payment (other than into certain permitted currencies (G-7 currency or OECD member with a local currency long-term debt rating of either AA or higher)).
2. Any reduction in interest or principal payable.
3. Deferral or postponement in the date of payment any interest or principal.
4. Restructuring is not considered to have occurred where it is not directly or indirectly related to deterioration in the creditworthiness or financial condition of the entity.

Voluntary restructuring – entailing lenders agreeing to Greece exchanging existing bonds and loans with one with different terms (longer maturity, different rates) – may not constitute a credit event under the CDS. This is because lenders would be agreeing “voluntarily” to subscribe to new debt which would be used to pay off existing or maturing debt. The original debt may not have been “restructured” in legal terms.

This means that, for Greece, only a “hard” default – a failure to pay, full debt rescheduling or non-voluntary or forced exchange – would allow the CDS protection buyer to trigger the contract.

In contrast, the rating agencies have indicated that any such voluntary exchange will be regarded as “selective or restrictive default”. Depending upon the terms of the exchange, the new bonds may trade at prices below par (based on experience of previous such exchanges) reflecting differences between the return demanded by markets relative to the new bond’s economic terms. This will result in investors incurring losses.

Where the CDS was entered into to hedge existing bonds or loans, inability to trigger the contract will mean that investors will not be compensated for any losses on any bonds or loans held. They will also have incurred the cost of hedging for the ineffective CDS contracts. Although the ongoing CDS contract may have some value as insurance against a “hard” restructuring in the future, there will be mismatch between the maturity of the restructured bond and the existing CDS making any benefit contingent on the timing of any default.

Where the CDS was entered into as a pure “bet” on the likelihood of a Greek default, the speculators who bet on there being no “default” will prevail, despite the economic reality of Greece’s “restructuring”.

The final arbiter of whether the Greek CDS has been triggered will be the Determinations Committee (“DC”), set up the industry association International Swap Dealers Association (ISDA), a voluntary body which governs the market. The DC comprises ten bankers and five investors. Unless backed by a supermajority of 12 out of 15 members, its decisions are externally reviewed by a committee of “independent experts”. While perfectly legal, the ability of a private body of financiers and lawyers to determine whether or not there has been “default” is unusual and legally untested.

For banks and investors who entered into CDS to insure against losses from a Greek “default”, the potential failure calls into question its economic effectiveness. As regulators and accountants assumed that the CDS eliminated or minimised risk of losses, the level of capital and reserves set against risk of Greek investment or the accuracy of financial statement may be incorrect.

An instrument where the intended consequences (protection against loss) can be manipulated by using different arrangements, with similar economic outcomes, has questionable utility as a hedge. The fact that an unelected and extra-judicial body of financiers is charged with settling any dispute adds to the problem.

None of these problems are new. The recent history of the CDS market is replete with disputes regarding the entity being hedged, whether there has been a credit event and the quantum of the actual loss suffered.

For example, the restructuring of MBIA also avoided triggering CDS contracts on the firm through the use of reinsurance.

The MBIA restructuring entailed the US municipal underwriting book being reinsured by a new entity – National Public Finance Guarantee Corporation (“NPFGC”). Reinsurance arrangements with FGIC were then ceded to NPFGC. NPFGC also issued second-to-pay policies to all policy holders covered by the assignment giving the beneficiaries a direct claim on the new entity and benefit from the credit quality of the new entity (that may be superior to the pre-existing MBIA). All other businesses including structured finance exposures remained with MBIA.

The arrangements were designed in part to avoid triggering the CDS contracts under the “restructuring” credit event. They were also designed to avoid the succession provisions in the CDS contract that would have required existing CDS contracts where MBIA was a reference entity to be split between MBIA and NPFGC. The effectiveness of the arrangements in not triggering the CDS contracts relied on highly technical readings of the contract specifically the concept of a “qualifying policy” under the Monoline Credit Derivatives Supplement.

The economic result of the arrangements was that MBIA retained the troubled structured finance exposures while losing the profitable and arguably less risky municipal re-insurance business. MBIA also reduced significantly the amount of capital it had available to support the exposures that remained with the firm.

MBIA was subsequently downgraded to non–investment grade. The downgrade reflected a reduction in MBIA’s claim paying capacity, reduced capital, transfer of reserves associated with cession of it’s municipal portfolio and the continued deterioration in the insured portfolio of structured credit assets. This materially increased the risk to sellers of protection in CDS contracts on MBIA. A number of hedge funds launched a class action against MBIA in relation to losses sustained as a result of the restructuring.

The technical nature of the arrangements highlights the potential legal issues present in CDS contracts. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract complicating significantly the effects of the contract and its efficacy as a hedge.

Ultimately, these problems raise a fundamental question: are CDS and, more broadly, derivatives useful and legitimate instruments of risk transfer or (in the words of one FT commentator) nothing “much more than a floating craps game in an alley off Wall Street“.

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  1. attempter

    The title is excellent. These “products” are indeed nothing but semantics, as the reality is nothing but a rigged game where the big players keep changing the rules “on the fly” as it says above.

    IOW, it’s nothing more or less than a political struggle, weapons and battlefields of class war. None of it has any substance at all beyond this.

    these problems raise a fundamental question: are CDS and, more broadly, derivatives useful and legitimate instruments of risk transfer or (in the words of one FT commentator) nothing “much more than a floating craps game in an alley off Wall Street“.

    It’s not possible to still honestly regard this as an unanswered question. We know beyond any doubt at all that Wall Stret does nothing but gamble, steal, and destroy.

  2. Diogenes

    Even if credit default swaps provided the protection that they were supposed to, how closely does that protection relate to the valuation of the referenced debt over time?

    For example, if a debt issuing entity goes into default on its senior debt but subsequently cures that default and pays back 100 cents on the dollar, how does this affect the timing and amount of any payout on a corresponding credit default swap?

    So long as the credit default swap was tied to an identifiable debt instrument that had to be surrendered in order to realize the value of the protection, this was probably a relatively unimportant consideration. But once the two became decoupled, it seems to me that the genie was really out of the bottle,

    To the extent that the payouts on the credit default swaps may be likely to diverge widely from the ultimate losses experienced on the corresponding debt instruments, is this asymmetric relationship generally understood by the parties who– for whatever reason– are induced to write the CDS policies in the first place?

    I don’t pretend to understand how these nuances play out but I hope that Mr. Das will, in a subsequent post, help to shed light on these intentionally opaque machinations since I suspect that they only heighten the systemic risk that these toxic instruments pose to the financial system.

  3. Smells Like Chapter 11

    You note:
    The final arbiter of whether the Greek CDS has been triggered will be the Determinations Committee (“DC”), set up the industry association International Swap Dealers Association (ISDA), a voluntary body which governs the market. The DC comprises ten bankers and five investors. Unless backed by a supermajority of 12 out of 15 members, its decisions are externally reviewed by a committee of “independent experts”. While perfectly legal, the ability of a private body of financiers and lawyers to determine whether or not there has been “default” is unusual and legally untested.

    This is just a form of arbitration. However, the real issue is whether the members and the committee of experts are sufficiently independent to to bind the parties. My guess is that there could be problems with this.

    I think that a lot of abuse of CDSs would be corrected if the swap could only be settled with physical delivery of the defaulted obligation. This should reduce the total amount of exposure by anyone counter-party. Further, the risk could be further reduced if one could not enter into the swap with out possession of the bond in the first place or even better if the bonds were escrowed with a third party. This would prevent a lot of the betting on your neighbor’s house to burn down.

    1. sgt_doom

      “.. International Swap Dealers Association (ISDA), a voluntary body which governs the market…”

      Hmmmmm….wasn’t one of the founders, JPMorgan Chase?

      If memory serves, the last time I checked the head of that was also the creator of the credit default swap, Blythe Masters?


  4. rc whalen

    Nice post. Makes you wonder how the Fed regulatory staff and research economists can continue to pretend that CDS is a valid indicator of default risk and effective tool for mitigation. Neither works post Greece.

    And just imagine a litigation with ISDA and these so-called industry committees. Eventually the Courts of New York will be forced to tell the “investors” that these are gaming instruments not enforceable at law. Ha. Chris

  5. xct

    This guy has confessed to a “new” bank business model in the Eurozone:

    SPIEGEL: In a monetary union, isn’t there a much greater danger that the crisis will spread from one weak member country to another?

    Homburg: No. The contagion spreads in precisely the opposite direction, because many banks and hedge funds benefit from the following business model.
    Step one: They sell the bonds of the country concerned.
    Step two: They spread negative rumors about the country.
    Step three: After bond prices have fallen, they buy them back cheaply.
    And, finally, they take governments for a ride with this nonsense that a default would have devastating consequences. In a zero-sum game, there are not only losers, like us taxpayers, but also winners.
    After the Greek bonds have been paid back at full value, the gamblers will turn to the next candidate, such as Portugal.
    If creditors suffered losses in Greece, however, they would renounce this business model. In this sense, the rescue measures are exacerbating the problem.

    SPIEGEL: If there were such a business model, a lot of people would be buying Greek government bonds now.

    Homburg: In recent days, I myself have invested a considerable sum in Greek bonds. They will mature in one year’s time and, if all goes well, produce a 25 percent return on investment. I sleep very soundly at night because I believe in the boundless stupidity of the German government. They will pay up.,1518,770673,00.html

    1. bmeisen

      Wonderful link! Recall however that Commerz, Postbank, and DZ are exposed in the range of 20 – 25% of their Eigenkapital. Assuming that their CDS, if any, is a dud, and they’re forced to take a buzzcut then they may also be forced to extend the moratorium on manager pay increases and bonuses.

      Thanks also to Yves for the Das article. Isn’t it remarkable that a private committee has its finger on CDS triggers? 10 bankers and 5 investors sitting apparently at the behest of ISDA! This compares with the MERS revelation late last summer. Please correct me if I am wrong but AIG was rescued from insolvency primarily by Bush and his agents giving it about 150 billion dollars (NY State pitched in about 20 billion right?)

      As I understand recent history, inslovency threatened because AIG’s credit worthiness was downgraded, which forced it to increase capital reserves, which it was unable to do immediately. Furthermore I understood that the downgrading was related in part to CDS exposure – IOW it wasn’t just their bad investments, for example perhaps in Lehman, that undermined their creditworthiness. They had sold a lot of CDS right? The ratings agency saw a problem, downgraded, and shortly thereafter Bush & Co. stepped up with our wallet.

      What I find shocking is that – assuming my account is accurate and taking heed of Das – the CDS “threat” was dependant on the ISDA committee pulling the trigger.

  6. frank

    As we learned from the AIG fiasco. CDS buyers originally thought to hedge the exposure from the underlying security ended shifting the risk to the counter-party.

    These bets are like making a sports bet with a bookie who may or may not pay you depending on whether he can collect from the other losing players.

    The imbalance judges or 10 bankers to 5 investors is a rigged jury.

    Lastly, the alleged $5 billion of CDS outstanding on Greek debt that has been widely circulated seems to be grossly understated. Soros alone is short more than that.

    Intuitively France & Sarkosky would not be volunteering to convert if their exposure was that limited.
    Remember Societe de General let one rogue trader whiff $6 Billion by himself.

  7. fresno dan

    Considering how nebulous and unreliable these instruments supposedly are, how is it that they can have such an affect upon the market? Reading this, wouldn’t you have to be a loon to buy a CDS – that is, they only are effective when they aren’t needed???

    Say I need home insurance and I choose the company named “Grifter, shsyter, and looney” – low, low, rates guaranteed! Now the economic textbooks I read said that the most buyers would employ a quality and risk metric, and only a small percentage of buyers would risk that their homeowner insurance to such an unreliable company. Indeed, one would expect that the number choosing not to purchase insurance at all would far exceed the number choosing the obviously crappy insurance company. Its like jumping the turnstile to get on the subway – you don’t pay 25 cents instead of a dollar – if your gonna cheat you cheat all the way.

    So, are all the buyers of CDS idiots? Or do they KNOW they will be made whole, and we are the idiots? Considering as far as I have read that governments (save Iceland, and Sweden and Argentina from years back) believe that any haircut on any bond will cause the sun to go supernova, maybe its perfectly rationale to believe that the governments of the world will pay any price, beat any burden, etcetera etcetara to protect CDS owners.

    1. readerOfTeaLeaves

      I think it’s far worse than that.
      It’s a form of financial arson.

      Suppose I don’t really care whether or not you have insurance on your house. It’s a nice house. So I’m going to buy insurance on it: I can only collect if *your* house burns down. I now have an incentive to be bloody well sure that your house burns.

      But suppose that I’m a really big crony capitalist. I claim that I am only ‘hedging’ to ensure that I don’t lose any value *if* (wink, wink) your house burns down. I am also going to ‘hedge’ my bets that Barney, Jimmy, Dina, and Verna’s houses don’t burn down. To ‘hedge’ (wink, wink) against any risk of my losing value if THEIR houses should happen to burn down, I take out ‘insurance’ (aka CDSs – ‘swaps’ are ‘insurance’) on THEIR homes.

      And it’s legal.
      And maybe my cousin Vinnie decides to pull the same scam that I’m pulling.
      And maybe our old buddie Joey or Frank want to get in on this scam as well.

      So me, Vinnie, Joey, Frank, and a buncha our friends and ol’ pals are all buying ‘insurance’ to insure against the remote possibility that our neighbors houses just might burn down.

      We now have a collective incentive for arson, since none of us gets a dime unless the houses burn down.

      As I read this post, the Powers That Be want to believe this is a ‘market’.

      This is *not* a market.
      This is an instance of a Tragedy of the Commons: we are all better off if the resources of houses and homes remain stable and we all get our dividends from mortgage proceeds on regular monthly payments.

      But instead, we got greedy.
      It was in our own, individual self-interest to buy insurance (swaps, CDS’s) on other people’s belongings — which we were able to do because *anyone* seems to be able to buy a sway on *anything*, *anywhere*.

      And because there is no exchange, there is no record of the fact that the insurers have now contracted to pay (at a minimum, with me, Joey, Frank, and Vinnie) four times what the each house was actually worth. Depending oon how many pals and buddies we have working this scam, these insurers could have taken in hundreds of insurance premiums, for all any of us know. But we all have contacts saying that we are owed money if those houses burn down.

      We may not have too much patience when the insurers go to the committee of 15 to claim that a house ‘demolished by conflagration’ is not the same thing as ‘burned down’. You see how much work their is for attorneys in this line of work… we’re going to pay a lot of educated people to fight over the meanings of words.

      So let’s go all write checks for a few judicial candidates, shall we?
      ‘Cause really, that’s probably our surest way to make certain that we can all collect on our outrageous bets.

      When people how have **zero** financial investment in a property or asset are allowed to take out insurance on that asset, we have a criminogenic environment. It appears to be on steroids and snorting coke.
      You’d think someone would wake up and distinguish between legitimate hedging and me, Vinny, and the gang ‘hedging’ our ‘bets’, but so far… it’s turning out to be mighty profitable, this whole financial arson thingy.

  8. hermanas

    @Fresno; “.. maybe its perfectly rationale to believe that the governments of the world will pay any price, beat any burden, etcetera etcetara to protect CDS owners.” I agree, so why the risk premium?

  9. Pat

    I was wondering how much Greek default CDS exposure there actually is throughout the world.
    First, I saw the figure of $100 billion, held by US parties. Then I saw $120 billion, or maybe Euros, presumably including European parties. Satyajit Das says there is only $5 billion.
    Zero Hedge has apparently done a reasonably thorough analysis and concludes that there is only $5 billion. So that is probably the real number.
    And at the end of he article, he explains that the chance of CDS writers not paying off is slim, because participants are pre-selected and because CDS writers have to put large amounts of margin, in cash, to pay off if they fail to do so.
    So it sounds like this Greek CDS contagion story has been fabricated to scare market participants into finding a solution to the Greek debt crisis, presumably through German/French contributions.

    Incidentally, FT mentioned something interesting about the Greek CDS. Apparently Greek banks wrote a lot of them, with the logic being that if Greece does default the Greek banks will dead already and won’t pay out.

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