Bloomberg News

Hunt for ‘Holy Grail’ Pits ECB Against Naked Banks: Euro Credit

June 17, 2011

June 17 (Bloomberg) -- European policy makers are on a collision course with the bond market as they seek to resolve the Greek debt crisis without triggering payouts under credit- default swap insurance contracts.

European Central Bank chiefs are determined to ensure any Greek debt restructuring won’t be deemed a credit event enabling buyers of protection to seek compensation from swaps sellers. It costs $2 million annually to insure against Greek default for five years, with Portuguese and Irish swaps also seeing all-time high prices.

A debt restructuring that doesn’t trigger swaps would be more damaging to the market as it would devalue contracts, according to analysts at JPMorgan Chase & Co. and Bank of America Merrill Lynch. Such a move would leave banks with unprotected, or unhedged, holdings, forcing them to sell bonds and ultimately drive sovereign borrowing costs higher.

“The ECB fears having to admit a colossal mistake when it declared euro zone governments as undefaultable,” said Georg Grodzki, head of credit research at Legal & General Investment Management in London, which oversees $580 billion of assets. “The ECB wants to protect its balance sheet and reputation.”

The ECB’s total exposure to Greece may be between 130 billion euros ($184 billion) and 140 billion euros, Dutch Finance Minister Jan Kees de Jager said this week. The ECB provided 90 billion euros of liquidity to Greek banks, he said.

Swaps Record

The decision whether to trigger swaps lies with representatives from 15 dealers and investors under the International Swaps & Derivatives Association. The committee, which includes Deutsche Bank AG and the world’s biggest money manager BlackRock Inc., rules whether a credit event should be declared after a request is made by a market participant.

“If you were to have an event and CDS did not respond, that means banks are naked,” said Christian Dinesen, head of international credit research at Bank of America Merrill Lynch in London. “And we don’t need any more naked banks.”

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

The extra yield that investors demand to hold 10-year Greek bonds relative to German bunds of similar maturity reached a record 15.43 percentage points today. The country’s two-year securities yield about 30 percent.

Default Probability

A failure to trigger credit-default swaps won’t necessarily render the contracts worthless. They may fall initially and then continue to rise on speculation the government will still default in future. Swap prices imply there’s about an 80 percent probability of Greece defaulting within five years.

“Just because one act doesn’t trigger, it doesn’t mean risk goes away,” said Andrew Sheets, head of European credit strategy at Morgan Stanley in London. “In high-yield, you have restructurings that are followed by hard credit events.”

Euro-area finance chiefs are struggling to break a deadlock on how to force investors to share the cost of Greece’s second rescue in 14 months without triggering a default. With consensus elusive before the target date of a leaders’ summit late next week, finance ministers agreed to convene again on June 19, a day earlier than planned. Talks may drag on into July, Luxembourg’s Finance Minister Luc Frieden said.

A “hard haircut” for investors in Greek securities would risk contagion to other European countries, Jean-Claude Juncker, head of the euro-region finance ministers group, was cited as saying in an interview with German newspaper Tagesspiegel.

“We have absolutely no experience as to what may happen if a member of a unique monetary union such as this one were to take such a step,” Juncker was quoted as saying. “The risks are so big that I can only warn of such a move.”

‘Holy Grail’

“The holy grail is to find a way in which to involve private sector participation, but without triggering a default,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “I don’t see how that’s possible.”

Swaps on western European governments can pay out on a credit event triggered by failure to pay, restructuring or a moratorium on payments.

A restructuring event can be caused by a reduction in principal or interest, postponement or deferral of payments or a change in the ranking or currency of obligations, according to ISDA rules. Any of these changes must result from deterioration in creditworthiness, apply to multiple investors and be binding on all holders.

Corporate Trigger

A voluntary “reprofiling,” as EU officials are calling a possible maturity extension, or exchange of Greek debt would not be a credit event, according to New York-based ISDA. Such agreements are often made with U.S. corporate bondholders without triggering swaps, said Steven Kennedy, ISDA’s spokesman.

“A default by any other name that does not trigger CDS means banks are not hedged,” said Dinesen at Bank of America Merrill Lynch. “That puts banks in an extremely precarious situation.”

The EU’s aversion to triggering swaps by restructuring contrasts with the stance of companies, which have become increasingly willing to facilitate settlement of derivatives linked to their debt. That’s because many investors in corporate bonds also buy insurance on their holdings and are more likely to agree to restructure bonds if they’re compensated for losses by swaps.

Irish Banks

Allied Irish Banks Plc offered on May 11 to call one series of notes later than others “to accommodate an orderly unwind” of swaps. The planned buyback is similar to an exercise carried out by the nationalized Anglo Irish Bank Corp., which agreed to stagger calls of its bonds last year so that securities would be available to use in settlement auctions.

ISDA ruled this week that swaps may be triggered after Allied Irish changed terms on its subordinated bonds, wiping out investors who refuse to accept as much as a 90 percent discount on their notes.

“Many corporate treasurers see a liquid CDS market on their debt as a positive benefit rather than a burden,” said Saul Doctor, head of credit derivative strategy at JPMorgan in London. “Treasurers have also realized that many holders of bonds are also holders of CDS protection and that they can no longer ignore these holders in any restructuring offer.”

One reason for the difference may be that fewer investors in government bonds use swaps to hedge. Credit-default swaps on Greece cover a net notional $5 billion, according to the Depository Trust & Clearing Corp., which runs a central registry that captures most trades. That’s just 1 percent of the government’s $482 billion of bonds and loans outstanding, according to data compiled by Bloomberg.

Italy Swaps

Swaps on Italy cover a net notional $25 billion, the most of any country or company in the world, according to DTCC. That compares with $2.3 trillion of debt. By contrast, swaps on General Electric Capital Corp., the top-traded company, cover $11 billion, or 3 percent of outstanding debt, and contracts on Berkshire Hathaway Inc., which have about the same net notional value as swaps on Greece, cover 28 percent of the company’s debt.

“Structuring a Greek restructuring so as to specifically not allow CDS triggers seems to be missing the wood for the trees,” JPMorgan’s Doctor said. “A major disruption to the market will cause hedgers to reconsider the value of their hedges.”

--With assistance from Jan Dahinten and Sunil Jagtiani in Singapore, and Chris Anstey in Tokyo. Editors: Michael Shanahan, Mark Gilbert

To contact the reporter on this story: Abigail Moses in London at Amoses5@bloomberg.net

To contact the editor responsible for this story: Paul Armstrong at Parmstrong10@bloomberg.net


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