Bloomberg News

Credit-Default Swaps as Hedge Threatened by Greek Debt Plan

October 28, 2011

(Adds swaps rally in 17th paragraph.)

Oct. 28 (Bloomberg) -- Confidence in the credit-default swaps market may be undermined by the European Union’s plan to resolve the euro region’s sovereign debt crisis.

The EU said yesterday that it reached an agreement where banks will write down their holdings of Greek bonds by 50 percent. The International Swaps and Derivatives Association’s chief lawyer later said because the deal agreed to by the Institute of International Finance is considered voluntary, it won’t require firms that sold a net total of $3.7 billion of credit protection on Greece to pay buyers of the swaps.

“I would probably shy away from CDS in the sovereign markets and some of the more mega companies in the world,” David Withrow, the head of taxable fixed income at Fifth Third Asset Management in Cincinnati, said in a telephone interview. “Politics are too much involved in the sovereign game and potentially even too-big-to-fail companies.”

Politicians and central bankers came to a last-minute deal after banks, the biggest private holders of Greece’s government bonds, were threatened with a full default on their debt, according to Luxembourg Prime Minister Jean-Claude Juncker.

As part of the accord, politicians and central bankers said they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities. Restructurings are only considered credit events when they bind all bondholders, according to contract definitions overseen by ISDA that govern credit swaps.

‘Arm Twisting’

ISDA General Counsel David Geen said the industry group, which runs a committee of banks and investors that determines when contracts pay out, considered the agreement to be voluntary, even if there may have been “a lot of arm twisting.”

“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”

Leaders in Brussels also agreed to boost Europe’s rescue fund to 1 trillion euros ($1.4 trillion), to recapitalize banks and get a commitment from Italy to do more to reduce debt.

The talks were regarded by many investors as a last-ditch attempt to stem the sovereign crisis, while preventing the contagion to Spain, Italy and Portugal that they worried a trigger for swaps would cause. The involvement of the IIF, which represents lenders, helped progress toward an accord that the EU could portray as non-mandatory.

Banks Threatened

That approach threatens to affect banks that use the swaps to hedge their holdings of government bonds, forcing them to look at other ways of laying off risk. The contracts 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.

“It punishes the banks that were well-hedged and managed, and I think it’s just starting to sink in as to what this might mean,” said Peter Tchir, the founder of hedge fund TF Market Advisors in New York. “Bank hedging desks are definitely now trying to re-evaluate” their use of default swaps, he said.

Deutsche Bank AG, Germany’s biggest lender, used credit swaps to help cut its net sovereign risk related to Italy to 996 million euros as of June 30, from 8.01 billion euros six months earlier, Chief Financial Officer Stefan Krause said July 26. The Frankfurt-based lender said this week it has since increased its risk associated with the nation’s debt as it stepped up market making.

Market ‘Dislocations’

“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” said Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros.

German Finance Minister Wolfgang Schaeuble is among European politicians who have expressed concern that the contracts have worsened the euro region’s troubles. Speculators can use them to benefit as a nation’s creditworthiness declines because the price of the insurance they offer rises.

ISDA’s Geen, speaking yesterday on Bloomberg Television’s “InsideTrack” with Erik Schatzker, said the agreement probably won’t trigger the swaps because it’s voluntary, even with the possibility of some “coercion.”

The matter “is borderline,” Geen said, adding that whether to trigger swaps on Greece is a matter for ISDA’s Determinations Committee.

Swaps Fall

The cost of insuring Greek and other European sovereign debt fell. The Markit iTraxx SovX Western Europe Index of credit-default swaps on 15 governments dropped 11 basis points to 277.5 as of 11:05 a.m. in London, the lowest since Aug. 17. The gauge has declined 17 percent since euro-region leaders announced the rescue plan, signaling more optimism about nations’ creditworthiness.

Swaps backing $10 million of Greek debt for five years cost $5.2 million in advance and $100,000 annually, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market.

That implies an 81 percent chance of default assuming investors recover 32 percent of their holdings. The probability is down from 90 percent earlier in the week, when the upfront cost was more than $6 million.

The net notional value of default swaps outstanding on Greece has fallen from $5.3 billion at the start of the year, according to the Depositary Trust & Clearing Co., which maintains a warehouse of trading data. The total is a fraction of the $390 billion Greek bond market.

ISDA rebutted suggestions that the swaps not paying out means they don’t work as a hedge in a statement on its website.

No ‘Catch All’

“It has always been understood that the restructuring definition cannot catch all possible events,” according to the statement. “If a creditor is hedging using CDS, and declines to participate in a voluntary restructuring, then the creditor would still hold its original debt claim and its CDS hedge.”

Much still needs to be resolved after the 10-hour Brussels talks, including how to strengthen the euro region’s 440 billion-euro bailout fund and what banks will get in return for accepting the writedown on their Greek bonds.

This includes the collateral they’ll be given and whether future bank debt is backed by a national or European guarantee. Either way, the deal will likely be structured as a voluntary agreement to avoid a default-swap trigger.

“It is symptomatic of the regulatory and legal goalposts being constantly shifted either randomly or to suit political interests,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London. “For genuine long-term investors, either financial or non-financial, it’s a major liability.”

--With assistance from Esteban Duarte in Madrid, David Goodman and Nicholas Comfort in London and Shannon D. Harrington, Abigail Moses, and Mary Childs in New York. Editors: Paul Armstrong, Andrew Reierson

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

To contact the editor responsible for this story: Paul Armstrong at parmstrong10@bloomberg.net


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