A not-so-funny thing happened on the way to the latest Greek bailout.
The terms and conditions of the bond swap Greece agreed to before getting another handout constitutes a theoretical default – but not a technical default.
That's not funny to CDS holders.
Greece hasn't defaulted (so far), but some of the buyers of credit default swaps, basically insurance policies that pay off if there is a default, claim the terms and conditions of the bond swap constitutes a "credit event" or default.
If it is, they want to get paid.
While on the surface this looks like a fight over the definition of a default, underneath the technicalities, the future of credit default swaps and credit markets is at stake.
In other words, the ongoing Greek tragedy is really becoming a global tragedy of epic proportions.
The Next Act in the Greek Bailout?
Here's the long and short of it.
Greece needs to make a 14 billion euro ($19 billion) payment on its huge outstanding debt on March 20, 2012.
The problem is Greece doesn't have the money, even after the previous 100 billion plus euro bailout.
If it doesn't make the payment it will be in default and all hell will break loose.
That means banks that hold Greek bonds won't get all their money back and they will have to write down Greek debts to zero.
That will trigger contagion as other countries in Europe will be seen as vulnerable to default too, and as panic in Europe grows from depositors trying to get their money out of insolvent banks, the spillover will infect world markets.
That's the case for contagion.
While cobbling together another bailout for Greece, this one worth 130 billion euros ($172 billion), the ECB, the EU, and the IMF (the Troika) are asking existing "private" bondholders, meaning banks and investors, to swap bonds they currently hold, with their high interest coupons, for bonds with half the face amount paying less than 4% interest.
The idea here is that there's no point in bailing out Greece with fresh money if it won't have enough money to make payments on the new debts it is incurring.
By swapping their existing bonds with a face value of 100 euros for new bonds with a face value of 50 euros (that's known as a 50% "haircut") and accepting a lot less interest, bondholders will be getting something as opposed to nothing if Greece defaulted and repudiated its outstanding debts.
The bond swap is being called "voluntary," meaning private investors will be swapping their bonds because they choose to.
There's only one reason to make such an unprecedented offer to existing bondholders, that's because if it wasn't voluntary it would constitute a "credit event."
Unanswered Questions Lurk Behind a Default
What constitutes a credit event is ultimately determined by a 15-member committee, known as the Determination Committee, within the International Swaps and Derivatives Association (a private group of derivatives dealers and bankers).
If the Committee says a credit event is a credit event, it constitutes a default and triggers the payment process, known as an auction, by which credit default swap holders get paid.
That's a global problem that nobody wanted to face and would likely trigger its own version of contagion.
No one knows exactly how much CDS paper has been issued and in the event of a default, who will owe whom how much, or if the counterparties that owe buyers of CDS insurance have the money to pay them.
So who bought a lot of this insurance? The banks that hold Greece's bonds bought CDS insurance.
Who did they buy the insurance from? Each other and hedge funds.
The problem is twofold when it comes to this scenario.
First, banks have been pretending that the Greek bonds they own and haven't marked down don't have to be marked down, because they have insurance on them.
Second, what will bank balance sheets look like if they have to pay out on the CDS paper they wrote, and what will they look like if they don't get paid by other banks or hedge funds that don't have the money?
What's more, what if there are insurance companies, like AIG (NYSE: AIG) that wrote them insurance and can't make good on it?
The unknowns are off the charts.
A Bad Situation Made Worse
In this case, it didn't matter how Greece was going to get its bailout money. What mattered was that it wasn't considered a "credit event," which would trigger the CDS contracts.
But, things got worse.
The ECB didn't want to take any hit or haircut on the 40 billion euros of Greek bonds it had bought to support the market. It swapped them with Greece for some new bonds that pay them less interest, but they didn't have to haircut the principal they're owed.
That was clever. You see, the new bonds they swapped for are, well, new bonds.
They aren't subject to the haircut that the private bondholders are being asked to take on the "old" bonds.
Nice trick, right? Yes, it was.
On top of that, as private bondholders got upset, it was decided that because not all of them might volunteer to take big losses, new, retroactive covenants would be put onto the old bonds.
These collective action clauses, or CACs, now allow a vote of 2/3 of existing bondholders to make decisions that all bondholders have to comply with.
All this is making CDS holders very angry. Well, not all of them.
The banks that wrote CDS insurance don't want to have to pay each other or anyone else. They'd rather hide behind the voluntary swap and get on with pretending Greece will survive.
But, by the ECB essentially screwing private bondholders by unilaterally taking a "senior" creditor position and by forcing collective action clauses on bondholders that never imagined buying bonds that had such clauses (they didn't when they bought them), the whole swap deal has created a hole in what constitutes a credit event.
Yesterday, the Determination Committee (made up mostly of the same big European banks that own Greek debt and wrote CDS paper to each other) determined the swap wouldn't constitute a credit event. Although they also said, that could change.
Even More Unanswered Questions
Now you know exactly how a de facto default doesn't become a "credit event."
The problem now is what to do about credit default swaps. Are they worthless?…
Will anyone ever trust them again as being legitimate insurance on credit instruments? What will happen to this $300 trillion market? …
What will this mean for less than stellar debt issuers who are able to sell their suspect bonds because investors could buy default insurance?…
What does all this mean for the sanctity of contracts? After all, bonds are contracts.
Global markets are going to have to figure out the answers to these questions and what it will mean for future markets.
Today, it is completely muddled.
The best we can hope for is that there's time to figure it all out before skeptical investors pack it in and sell what they have no control over and have no faith in anymore.
Unfortunately, the Greek tragedy is only the first act.
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Related New and Articles:
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