Some reflections over G-Day
Another day in the sovereign debt saga, another hurdle taken. The Greek government overnight has announced it has reached its target in the biggest sovereign restructuring in history. The participation rate among investors amounts 95,7%. Bondholders tendered 152 bio EUR of Greek-law bonds (85,8%), complemented by 20 bio EUR of foreign-law bonds. The goal of the operation was to reduce the 206 bio of privately held Greek debt by 53 %. This Greek debt swap was a vital key element in a more broader rescue deal together with the Troika 130 bio EUR rescue "loan". Right or wrong is not the object of this little comment. And it goes in the same line of my comments some days ago where solving 1 specific problem by an emergency rescue measure (like LTRO) causes problems elsewhere in the market.
The legal problem right now is the fact that under standard ISDA rules (Intern. Swaps & Derivatives Association), the fact collective action clauses have been triggered should normally be followed by labeling this event as a "credit event", in this case a default. And if that is the case, then CDS contracts should be triggered as well. Which means that those who sold protection on Greek sovereigns could face some reimbursement towards the ones who hedged or went naked long CDS. The ISDA committee so far has not been willing to call this a credit event, probably under strong pressure from the continent, London and NY. This afternoon at 1 PM, they will have a new meeting in order to consider the Greek event as a "potential credit event".
In the meantime, the volume of CDS contracts on Greece has tumbled, with the net amount of debt protected representing less than 1% of Greek sovereign bonds and loans outstanding (2,4 bio EUR), down from 4,2 bio EUR a year ago. And this could have serious consequences.
The fact that the CDS market is dead is no surprise with the current legal uncertainty over "to trigger" or "not to trigger" the contracts. When you are an investor, you are faced with choice and choices usually involve risk. Choosing not to invest in a certain asset is risk as well (opportunity profit). But when you have decided to take on the risk of buying an asset, you would like to know up front whether you can hedge the position and how much such an insurance hedging cost amounts. Now if the hedge a posteriori seems useless - and that's why Greece is a dangerous precedent - will you be tempted to buy the underlying asset in the future ?
The question is relevant because by destroying the CDS market, you are increasing the risk of sovereign bond markets as well. And you see this already with scarce liquidity not only on Greek bonds but also on others. So this legal uncertainty over the derivative product might create problems for the cash market in the future. And may be we already have some evidence over this. When looking at the evolution of the yield curves of Spain, Portugal and Italy, we see the following trends:
1) 5yr Portuguese sovereign CDS since the announcement of LTRO1 and 2 has barely budged. In fact, it even worsened in the month of January from 11% premium in December to a peak of 16% to stabilize for now around 12%. This says something about the "liquidity" and current "attractiveness" of this market in the eyes of the investor. As a consequence, the Portuguese cash market is a dead duck as well, barely profiting from the LTRO Sarkozy-Draghi carry trade.
2) Looking at Spanish and Italian CDS/cash market evolution, it's better but it's clearly differentiated. The environment certainly improved but it improved far more better for Italy than for Spain. Now why would that be the case ? Admitted, the carry on Italy was more attractive from the start but since a week, rates on 10y Italian BTPS dived under 10y Spanish Bonos and it has been a while for that to occur. Markets putting more confidence on Monti than on Rajoy or are the Italian fundamentals significantly better ? May be. And being short on an index heavy weight like Italy (25%) is of course more "dangerous" than being short on Spain (10% of the index) which for the majority of benchmark portfolio managers is their traditional perception of risk of not being invested in a particular asset. But my guess is that Mr Market is positioning himself for the following events : now Greece is of the table for the time being, the focus will potentially shift towards Ireland (referendum on EMU) and inevitably towards the Iberian Peninsula. And when Portugal appears on the radar screen, so will Spain. And then may be in the eyes of a moral hazard manager, Italy is a safer bet than Spain in terms of too big to fail. Never mind that it's too big to bail.