A Year of Me-Firsts, and of Lessons Relearned in Sunday’s New York Times recounted “some truly illuminating moments” from 2011:
“A favorite was the pronouncement that if Greece were to default on its debts, it wouldn’t really count as a default at all. That determination meant that investors who had bought insurance against a possible default would be out of luck. Their policies wouldn’t pay off as expected.
Who ginned up this nondefault default? A secret committee of bankers who call the shots in the world of credit default swaps. These people happen to work for big banks that probably sold the insurance and, as a result, would be on the losing end if a Greek default were actually called a default.
It sure is good to run the Wall Street branch of the Ministry of Truth.”
The Orwellian reference certainly seems apropos. But not perhaps for the reason originally intended. The fact is, ignorance is not strength: none – not one — of the statements in this excerpt are true. Isn’t that a little Orwellian?
We’ll go through each in turn, but before doing so want to point out an important fact. The sovereign CDS exposures of four firms that sit on the ISDA EMEA Determinations Committee were made public as part of the European Banking Authority’s 2011 EU Capital Exercise. The total of their net exposure on Greece? $276 million. One firm had net exposure of $3 million; none had net exposure of more than $100 million.
What this means: It takes 12 of 15 votes to declare that a credit event has – or has not – occurred. Five of those 15 votes belong to the buy-side. When it comes to Greece, at least four more of those votes belong to firms without a substantial net CDS exposure to that sovereign name.
Now to our line-by-line analysis:
A favorite was the pronouncement that if Greece were to default on its debts, it wouldn’t really count as a default at all.
There was no such pronouncement. What ISDA actually stated at the time and which remains true today is:
“The determination of whether the Eurozone deal with regard to Greece is a credit event under CDS documentation will be made by ISDA’s EMEA Determinations Committee when the proposal is formally signed, and if a market participant requests a ruling from the DC. Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts. In addition, it is important to note that the restructuring proposal is not yet at the stage at which the ISDA Determinations Committee would be likely to accept a request to determine whether a credit event has occurred.”
That determination meant that investors who had bought insurance against a possible default would be out of luck. Their policies wouldn’t pay off as expected.
CDS protection buyers and sellers expect their CDS contract to pay according to its terms. Those terms make clear that for a Restructuring credit event to occur it must be in a form that binds all holders of the “restructured” debt. While the DC has the final say, a voluntary exchange in which some bond holders can choose to keep their original holdings would not appear to be binding on all holders.
It’s important to remember that those Greek debt holders who do not agree to an exchange keep their existing debt and remain entitled to repayment of principal and interest according to its terms. Similarly, an owner of CDS protection on Greek debt continues to be protected if a credit event were to occur later (for example, if the Issuer were to miss a coupon or principal payment). The CDS protection buyer can, of course, trade out of the position the same way a bond holder could sell his/her bonds; given the direction of Greek CDS prices this would result in a profit. The market does indeed continue to see the value of CDS contracts.
Who ginned up this nondefault default? A secret committee of bankers who call the shots in the world of credit default swaps.
How can a committee be a secret if the names of its members are publicly available? (Answer: it can’t be – and it isn’t.) The firms on each of the DCs are posted on the web. So too are their votes.
In addition, the structure of the DC ensures that its determinations enjoy a broad consensus based on the public facts at hand and the CDS Definitions. Of the 15 DC members, 10 are sell-side and 5 are buy-side. 12 of 15 votes are required for the DC to make a determination (whether that determination is that a credit event has occurred or has not occurred). Otherwise the determination goes to a panel of outside experts.
These people happen to work for big banks that probably sold the insurance and, as a result, would be on the losing end if a Greek default were actually called a default.
As noted above, four of the banks on the ISDA EMEA Determinations Committee were included in the European Banking Authority’s recent 2011 EU Capital Exercise. Of these four, one is from the UK, one is German and two are French. (Of the six other banks on the EMEA DC, four are US and two are Swiss; these were not included in the EBA exercise.)
The four banks’ sovereign CDS exposures – the protection they sold and the protection they bought — were publicly reported as part of the EBA exercise. Each of the four was slightly long in its net exposure on Greece, meaning they had sold a bit more CDS protection than they had purchased. The total of their net exposure on Greece was $276 million.
Truth be told, 2012 looks like it will also be a year in which some lessons need to be relearned.