Some reflections over G-Day

Published: March 9, 2012 10:36 am
This article received : 15 Comments

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.

15 Responses to “Some reflections over G-Day”

  1. Nacht Und Nebel says:

    Greek is saved and can’t go bankcrupt anymore because we will pay their bill from 1990 until eternity

  2. Joeri says:

    Didn’t the ECB threaten in the past not to accept restructured government bonds as collateral if the ratings agencies decided that the Greek restructuring should be classified as a credit event?

  3. Philippe says:

    Has anyone considered having a look at ” la Grèce Contemporaine” by Edmond About, Librairie Hachette, 1858 ( yes, 1858, not a typo ) , chapter VIII “Les finances”. Truly worth a reading , as nothing actually changed

    “La Grèce est le seul exemple connu d’un pays vivant en pleine banqueroute depuis sa naissance”

    Let’s remember that this book was written before they let Greece inside the Latin Union. And that, by 1885 everyone in the Latin Union was pretty convinced that was a bad idea but no one knew how to get rid of the issue without major costs. ( The issue was the delicate balances between central bank liabilities, and it somehow became secundary after WWI as by then everyone except the Swiss had taken much worse damage and was thus ready to consider the issue as less critical )

  4. christof Govaerts says:

    The as usual optimistic colleague, and that when entering the weekend !!

  5. christof Govaerts says:

    It still is the case – no acceptance during interbellum of debt swap – but that will quyickluy be forgotten once this storm has blown over. If CDOs, CLOs and all the other stuff can be dumped in Frankfurt, why no Hellenic bonds ?

  6. christof Govaerts says:

    Yes we should have known better and most of us did in 1991 when already clear that Greece in no way strictly qualified for maastricht, even leaving aside the matter of cooking the books thanks to Goldman. And the paradox is that some former important Golmanites are now in positions trying to deal with this fiasco

  7. Philippe says:

    Are you sure that what they try to do qualifies as “dealing with”. Or is it “take advantage of “?

  8. Nacht Und Nebel says:

    grumpy says (lol):

  9. christof Govaerts says:

    If you imply that Draghi didn’t forget his transatlantic friends when pondering over LTRO, I am sure that some took advantage of this. I wouldn’t be surprised that the Goldman desk took a huge position on Italian bonds – and preferably leveraged as well – some days before LTRO was announced

  10. Jfv says:

    @ Christof

    Great summary. My only comment would be the following quote of Jim Sinclair:

    “The estimate of under $4 billion as the total notional value of the contracts outstanding is a serious understatement.”

    I think we would not see all the ISDA meetings etc. if we were only talking about a few billion dollars. So Sinclair may be correct on this one. I smell a rat somehow … and now the ISDA has just declared a “Restructuring Credit Event” has taken place. Almost sounds like Bernanke speaking. They did not utter the word “default”, so will the CDS be triggered? Monday may be rather interesting!

  11. Theo says:

    Spain is the new America.
    The property market is a very serious problem which just as in the US is dragging down everything else.
    How is Europe going to deal with that?

  12. Jfv says:

    Further up-date. If the latest from Jim Sinclair is true we may have another reason for a potential systemic crash. Then again a systemic crash wouldn’t benefit anyone. So let me correct myself on that one: We would be facing a possible tsunami of bailouts. But as I am sure you agree this is a finite kick-the-can-down-the-road solution as there can only be so much austerity before the populace will revolt en masse.

    Sinclair stipulates the following:

    “The release made by the International Swaps & Derivatives Association (ISDA), for the average Mensa member or genius, is totally incomprehensible. The press is using the word default, but the ISDA is using the word ‘auction.’ Clearly, the amount of CDS’s outstanding is infinitely more than the $3.5 billion that is being quoted.”

    He continues:

    “The BIS confirms, in the area of CDS’s the total outstanding is approximately $37 trillion. So I believe the reports being given about this just being a small and modest market event is false. As a market observer and having more than 50 years in the business, the real number is at least 50% or more of the existing $37 trillion that is related to Greece.”

  13. Jfv says:

    Add to this that 97% of the CDS’s are allegedly held/underwritten by 5 major international US banks – who are also ISDA members – and the global system could be in a world of trouble. Of course all hinges on whether or not the vague language of the ISDA will be construed as an official “default”. Moreover it is highly unlikely that the big banks would be caught with their pants down when it comes to CDS’s. It can also be argued that since they are in fact the private shareholders of the FED (not to be mistaken with the Federal Reserve Board) they would of course share in the profits of any additional “easing” (money printing through more debt creation). One can only wonder what kind of deals have been agreed upon away from the media spotlight. I smell a rat when big banks voluntarily agree to take an 80% haircut.

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