Standing in defense of principle

March 21, 2012 | Capital markets, CDCs, Derivatives, Global news, Greece, Law, Securitization, Workouts

By:David A. Smith


How many legs does a dog have if you call the tail a leg?


Uh – what was the question again?


Too seldom is something done just because it is the right thing to do, and because principle demands it.  When it happens, as it did two weeks ago, even if the courageous are unlikely heroes, their bravery must be saluted – and to understand why, we turn to Forbes (March 9, 2012):


A report by Derivatives Intelligence published around 2:00 PM New York time said the ISDA had indeed considered the PSI/debt restructuring deal a credit event.  


At the time, I said it was a waste of perfectly good betrayal, but the full European headless hydra strategy is only now unfolding.  By forcing bond swaps through a tranched approach to doling out periodic new liquidity for an obviously insolvent Greek state, the European Central bank is bailing out European banks (mainly German and French ones) by swapping bad Greek paper for new (presumably good) ECB paper, even at a large discount.


The Hellenic Republic executed the highly controversial PSIor debt restructuring deal, getting 85.8% of holders of Greek-law governed bonds and 69% of foreign-law bonds to tender.


The troika accompanied this coerced exchanged with a great deal of arm-twisting (to get private bondholders to go along) and hand-waving (to suggest that agreements extracted under coercion were ‘voluntary’, and hence not a default). 


Negotiation, Greek style


The troika needed this as additional coercive power, because if the swap were a default, then those who bought credit default swap protection would be paid in full, and that would make them far less likely to agree to a voluntary exchange of their current bonds for new ones.


While Greece hasn’t missed a bond payment yet, it has effectively defaulted by forcing a 74% haircut on those creditors that held out, as Fitch’s calculations in their recent downgrade of Greece’s sovereign rating to “selective default” show. The question of a Greek default may appear superfluous to some, given the country is relatively small and has been bailed out –


For now.  Greece is still bust because it hasn’t stabilized its revenue versus expenditures, so another round of lending/ crunching/ cutting will be required.


– but the resolution of the situation will set historical precedents that could take on massive importance if other peripherals, particularly Spain and Italy, face serious financing problems.


The ECB’s mandatory-voluntary exchange all has a Catch-22 self-verifiability: if there is no default, then CDS holders would have no protection, and they would swap voluntarily, and if they swapped voluntarily, why then there would never have been a default!


There was only one catch, and that was Catch-22


Despite all their suasion, blandishments, and threats, the European troika could not get unanimity.


Greece announced that holders of €152 billion of bonds governed by Greek law –


As we’ll see in a moment, Greek law had a cramdown loophole.


– of the approximately €177 billion issued, voluntarily tendered their bonds and accepted a 74% haircut. Also included in the deal were holders of laws governed by foreign law, generally British or Japanese, who tendered €20 billion or 69% of bonds outstanding.


The bondholders had their deal changed against their will:


Using retroactively inserted Collective Action Clauses (CACs), Greece [forced] bondholders governed by domestic law to take the deal, as long as they [met] a certain threshold.


Remember, most of the Greek bonds were held by government banks, so naturally the government-owned banks would vote to accept a deal being forced by their own governments.


We are fully independent bankers, can’t you tell?


Beyond the 85.8% of those bondholders that tendered their bonds, an additional 5.3% (about €9.38 billion in face value) voted to force the restructuring terms, without tendering their bonds. Presumably, that 5.3% consists of bondholders that bought CDS protection, and need the CAC implementation to trigger that protection.


At the end of the day, this means Greece is forcing 9.9% of bondholders under domestic law to both accept the retroactively inserted CACs and to take a 74% haircut (according to Fitch’s calculations).


Private owners thought they had the same rights governments did.  They were wrong.  Once begun, every betrayal leads to another betrayal.


Just to clarify, an additional 5.3% held out but voted to enforce the CACs, presumably because they bought CDS to cash-in on Greece’s sovereign debt crisis.


In effect, Greece is becoming a wholly owned subsidiary of the European Central bank, like the Washington Nationals were one owned by MLB or the Charlotte Bobcats by the NBA, except that the people of Greece don’t necessarily realize their favored status, and are likely to go a little bonkers.


You’re all gonna be thrown out of the league


It’s all down to the ISDA now.


As I understand it, the ISDA is essentially an industry referee, elected by and accountable to the CDS marketplace members themselves.  It’s a member-appointed and member-governing body and as such its constituents are at any given moment on all sides of any particular risk trade (where one party buys the risk, by issuing insurance, and another party sells the risk, by buying the insurance).  Naturally the adjudication of any given settlement will please some ISDA members and displease others – that’s what happens in bilateral trades. 


The issue of moral hazard is unavoidable within the ISDA. Among the parties voting to determine if there will be a credit event in Greece are institutions like Goldman Sachs, Morgan Stanley, JPMorgan, Deutsche Bank, BNP Paribas, and Societe Generale. Hedge funds like Elliott Management, Citadel, and D.E. Shaw are part of the decision-making group too. Some of these institutions have tendered their bonds, others, probably, have placed their bets on a Greek default.


You can’t all win, you know


Yet the economic health of all of their members depends entirely on the health and efficiency of the market, and that means clear bright-line boundaries, decisively adjudicated.


Meanwhile, the European troika seeking to force creditors to take what they are given on ersatz Greek debt was doing everything it could to prejudge the issue.


The group has been under fire by the media for failing to consider Greece in default when it was clearly imposing a massive haircut on its creditors. To the ISDA’s defense, no bondholder had actually suffered a haircut.  


Adjudicators, like courts, have learned over the decades and centuries not to answer unripe or unasked questions.


We’re not tasting them yet


The reason is simple: if one gets into the habit of answering hypothetical questions, not only does one’s workload expand infinitely, one can be gamed, answering infinitesimally different variations of the same question over and over until the scales tip the other way.  That makes for wasteful judging and results-merchant jurisprudence.


However, the moment comes when decision is required:


As of Monday, March 12, when Greece implements the swap, this will have occurred, against the will of 9.9% of those bondholders.


Now there’s right and there’s wrong


And that is why the International Swaps and Derivatives Association’s decision on CDS is actually transcendental.


I think they mean ‘precedential.’


Inasmuch as anything has meaning, you’re right


The ISDA was set to meet at 1PM London time on Friday, March 9, to figure out if a restructuring credit event had occurred, a circumstance that would trigger CDS.


Both Nomura and Barclays have come out expecting the ISDA to rule in favor of a credit event, thus triggering CDS protection.  The net notional value of CDS outstanding is relatively small, around $3.2 billion. Barclays’ analysts considered the process to be “relatively uneventful” given how small the actual liabilities are. But they are missing the point.


They are indeed.


Don’t fire unless fired upon
But if they mean to have a war
Let it begin here


As the ISDA has made clear in the past, these products are in their infancy and are in a process of evolution. The Greek restructuring is a defining moment for CDS and other derivative products, giving the ISDA’s decision value in terms of precedence, much like a in a legal system based on jurisprudence. The net notional value of total CDS outstanding is $15.7 trillion according to DTCC, that’s larger than the U.S. economy.


At stake is a principle on which the whole ecosystem of credit-default protection was founded, and while the business has taken its share of knocks in the public arena (some deserved, some not), it adds value to the ecosystem because it allows efficiently migration of risk. 



Whatever the ISDA decides, the future of CDS is on the table.


Without CDSs, no securities could be insured privately, the supply of capital would shrink, and hence its cost would rise and its adaptability and responsiveness fall.


And, if the European sovereign debt crisis takes a turn for the worse, as it probably will, and Spain or Italy come under fire by bond vigilantes, then the ISDA’s decision on Greece will take on added importance.


For months now, the European authorities have pressured the ISDA and its members all they could (including asserting legally dubious provisions of Greek law), whittling away at the holdouts until only a few remained.  In this they were using the power of the sovereign to break its own rules without consequences, which is immoral because it is practical.


‘Speak truth to power’ – isn’t that the self-congratulatory definition of courage offered by those who protest where there is nothing on the line? 


Fortunately, there is a straightforward answer.


Calling something not a default is not the same as it’s not being a default.


Four. Calling a tail a leg doesn’t make it a leg. Abraham Lincoln


The ultimate in political courage


UPDATE 2 (2:48 p.m.): ISDA has now declared that Greece’s restructuring does represent a default, meaning credit default swaps will trigger. Read the statement.


Here is the full statement:


EMEA DC Statement

March 9, 2012

In light of today’s EMEA Determinations Committee (the EMEA DC) unanimous decision in respect of the potential Credit Event question relating to The Hellenic Republic (DC Issue 2012030901), the EMEA DC has agreed to publish the following statement:


Remember that unanimous – it’s an important signal of resolution.


Write it big enough to be read without glasses


The EMEA DC resolved that a Restructuring Credit Event has occurred under Section 4.7 of the ISDA 2003 Credit Derivatives Definitions (as amended by the July 2009 Supplement) (the 2003 Definitions) following the exercise by The Hellenic Republic of collective action clauses (CACs) to amend the terms of Greek law governed bonds issued by The Hellenic Republic (the Affected Bonds) such that the right of all holders of the Affected Bonds to receive payments has been reduced.


The gauntlet is thrown down – CACs are a breach of contract.


It is a breach, sir!


The EMEA DC has resolved to hold an auction with respect to the settlement of standard credit default swaps for which The Hellenic Republic is the reference entity. To maximise the range of obligations that market participants may deliver in settlement of any such credit default swaps, the EMEA DC has agreed to run an expedited auction process such that the auction itself will take place on March 19, 2012. In light of this expedited auction process, market participants should submit any obligations that they would like to include on the list of deliverable obligations to ISDA as soon as possible.


Less elegant than the Declaration of Independence, but it’ll do.


The unanimous declaration, in Philadelphia