Default Events, Legal Contracts, Derivatives, and Greece
Barry Ritholtz, who generally knows better, blew a gasket at ISDA for yesterday’s ruling that Greek bonds are not yet in default. Specifically,
“The International Swaps and Derivatives Association said on Thursday that based on current evidence the Greek bailout would not prompt payments on the credit default swaps.”
Here is a question for the crowd: Exactly how brain damaged, foolish and stupid must a trader be to ever buy one of these embarrassingly laughable instruments called derivatives?
The claim that Greece has not defaulted — despite refusing to make good on their obligations in full or on time — is utterly laughable.
Let’s sidebar the reality—that there is no true “market” for CDS in general, let alone Sovereign Debt CDS; Donald R. van Deventer of Kamakura Corporation has been all over this, both on his blog and especially on Twitter—and just note that ISDA made the correct decision.
Greece has not, to borrow Barry’s phrase, “refus[ed] to make good on their obligations in full or on time.” ISDA did not declare a Default Event yesterday because there has not yet been a Default Event.
Default Event is a very specific term. The sample in Janet Tavakoli‘s Credit Derivatives and Synthetic Structures (a book to which I have referred before and undoubtedly will again) runs pretty much three full pages (pp. 88-91). But the general concept is straightforward: there is a minimum threshold (say, 10% of an issue), the principal or interest due of which the entity explicitly refuses to pay or fails to pay that then materially impacts the buyer of Credit Protection (CDS).
Greece has not yet refused to pay anything.*
There is a payment due on 20 March—19 days still in the future. The financial markets—heck, everyone who runs a diner in Queens—may well believe that no payment will be made on 20 March, but that hasn’t happened yet. And the Greek government specifically has not said it won’t make the payment; it has said, “Hey, take these bonds instead.”
It is true that, cet. par., the market value of the bonds being offered is about 25% the supposed economic value of the current ones. So anyone taking the deal would have to be assuming that the market value of the current bonds is somewhere around 25, just as the French and German banks have them marked.
The market may also agree that one of the reasons people may well accept the offer is that, otherwise, they expect that the Greeks will default on the current bonds.
But they haven’t yet, and this is not Minority Report (though we can all agree Phil Dick would recognize, if not approve of, the current financial world).
So ISDA correctly ruled—the key phrase is “based on current evidence”—that there is not yet a Default Event. If everyone says “we will tender our securities due 20 March for the exchange offered,” there will not be a default of those bonds.
You, I, and Bill Gross can all agree that the likelihood of this happening is about equal to the chance that Rick Perry will be elected U.S. President this year. But there has not been a Default Event.
Wait two or three weeks.
The thing Barry most overlooks is that yesterday’s ISDA ruling is, if anything, good for CDS buyers.
What will be the economic difference of waiting to holders of the CDSes? I don’t know for certain, but if you’re looking at the standard ISDA CDS contract, there’s a reasonable assumption that (1) the market price of the bond will not change for the better and (2) it is a certainty that the Accrued Interest on the bond will be greater when they declare a Default Event than it is now.
Keep in mind: in a standard CDS, declaration of default terminates the contract. Accruals end, market pricing is to be determined by calling a few dealers, and the only thing left is to go through the pockets and look for loose change.**
Yesterday’s ISDA ruling means the CDS buyers will be owed more Accrued Interest when (in two, or at most three, weeks) a Default Event is declared.
What about the principal repayment due? Recall again that the payment due is generally the net of the current market price subtracted from the initial principal amount (assumed to be par—100—but in any event greater than the current market value).
I’m inclined to argue there is optimism in the current market that will not be there in two weeks: it’s not that liquid a market, there is a floor on the price of the economic equivalent of the new offer, and there is time value in the option to convert.***
If ISDA had declared default yesterday—that is, assumed that Greece wasn’t just “mostly dead”****—they would have taken the current market price [P0]. Even before the delays and roundelays, that was likely to be greater than the market price of those bonds in a week or two[P1, when default is declared.
That is, P0 is greater than P1. And since the payment due is based on [100*****-Pt], the principal amount due to CDS holders when default is declared will also be greater.
ISDA followed the letter of the contract: the Greeks have not yet defaulted on an obligation, nor have they stated that they intend to do so. When they do—there are few, if any, in the market who would treat the clause as a possible “If”—a Default Event will be declared and the CDS contracts will be expected to pay as they are due. And that payment will, in all likelihood, be higher than the payment that would have been due if ISDA had ruled differently yesterday.
And if they don’t, then I’ll be agreeing with Barry that the whole thing was a scam from the start—though I would still argue that JPMorganChaseBear stealing more than $1,000,000,000 in customer funds from MF Global clients is a bigger one, which is something like saying that coprophagia is even worse in liquid form.
When the CDS contracts actually have to be paid, then the fun will begin. If potential for insolvency is your idea of fun. But that’s another story.
*They have seen S&P downgrade their credit rating, but that’s a separate issue.
**Obligatory reference. It will pay off.
***The Worst Case scenario is that you assume the new bonds are the only value in the transaction, and discount their value back over the cost of basically two-week money. The best case scenario is some combination of the price of the new bonds and expectations of either getting a better deal later and/or post-litigation gains. The lattice may be ugly, but it yields an expected value higher than the Worst Case, and therefore higher than the market price of the bonds as the time to exercise approaches.
****See ** above.
*****Or the other initial contract price; in any case, a fixed value greater than Pt.
“Hey, take these bonds instead.”
In order to make payment on a debt obligation, they offered up not cash, but another bond — they gave an IOU.
Um, can I do that with all my bills — repay my loans with additional promises to pay the loans? At a 75% discount? Thats a neat trick.
Here’s another definition of default: Would Vinnie the loan shark accept this as tender for the money borrowed? Or would he break Greece’s legs?
Vinnie knows much more about defaults thant he ISDA does . . .
Somebody Vinnie trusts says, convincingly, “Hey Vinnie: if you break Joey’s legs all your other customers will default as well.”
What does Vinnie do?
The distinction between the formal definition of a default and the common-sense one that Ritholz appeals to is both entirely clear, and of course a lovely demonstration of the gap between formalism and reality. Moreover, by elegantly following the letter of the contract — which is what they had to do of course — the ISDA nicely makes an important statement for investors about the nature of ‘credit’, namely that it rests, in the end on faith. Faith in the meaning of words (which clever lawyers and politicians can and will bend), and thus faith in the person of one’s counterparties. Way too many people over the last decade, I suspect, bought derivatives without considering faith; they plugged in equations, read contracts, and thought they were dealing with the world…but they were not. Now they are learning the appropriate lesson.
And if future CDS buyers learn from this episode, it will a good thing. Heding with CDS will no longer feel like a technical action — something you do because its consequences are predictable — and will instead become a judgement of faith, of credit. And CDS investors will be reminded of another important lesson, namely what it means to be a ‘sovereign’ in a system of law (cf. Jean Bodin ca. 1566). The Greek Parliament and government, as a sovereign, could change the rules regarding ‘Greek-law’ bonds, and it did. That’s what makes it a sovereign. For too long, sovereign debt was viewed as _safer_ because it was issued by sovereigns. But when Greece gave up its monetary sovereignty by joining the Euro, while keeping its jurisdictional sovereignty, and issued Euro bonds under Greek law, the die was cast (just as much as by entering the Euro).
Which might remind CDS holders that holding Greek bonds under British law is only better as long as they think that the British sovereign won’t change the rules too. And if you think such a change is impossible….well, I’ve got some great bridge shares to sell you, too.
Most broadly (and again importantly) this whole mess should again disabuse any sentient observer of the illusion that there are ‘markets’ that are somehow prior to and autonomous of the state, at least at any scale worth investing in. Without sovereigns, there ARE no markets, thus rendering risible the endless twaddle we hear about ‘freeing markets from the state’!