Default Semantics – Credit Default Swaps & Greece

The European Union’s linguistic gymnastics, redefining default as “restructuring” or “re-profiling” and the structure of any final deal on Greek debt has “real” implications for the arcane workings of the CDS market.

In the film Casablanca, Rick (Humphrey Bogart) tells Captain Renault (Claude Rains) that he came to the city because of his health, to take the waters. Informed that they are in the desert, Rick ironically replies that he was “misinformed“. Investors and banks that purchased Greek sovereign credit default swap (“CDS”) to protect themselves against the risk of default may find that they have been similarly “misinformed“.

The “hedges” may not provide the protection sought. While net outstandings of Greek sovereign CDS is modest (around US$5 billion), the current imbroglio raise important questions about the role and efficacy of CDS contracts generally.

Similar to credit insurance, in a CDS, the buyer of protection pays a fee to obtain indemnification against the risk of default of a borrower (Greece) and any resultant loss from a protection seller. Payment is triggered by a “credit event”, technically defined as failure to pay interest or principal, debt moratorium or repudiation or “restructuring”.

“Restructuring” is concerned with a material restructuring of an entity’s payment obligations or a forced substitution of new obligations. Generally restructuring will entail:

  1. Changes in the ranking of the debt, reducing seniority, subordinating the obligation or converting debt into equity.
  2. Change in the currency of payment (other than into certain permitted currencies (G-7 currency or OECD member with a local currency long-term debt rating of either AA or higher)).
  3. Any reduction in interest or principal payable.
  4. Deferral or postponement in the date of payment of any interest or principal.

Restructuring is not considered to have occurred where it is not directly or indirectly related to deterioration in the creditworthiness or financial condition of the entity.

Voluntary restructuring – entailing lenders agreeing to Greece exchanging existing bonds and loans with one with different terms (longer maturity, different rates) – may not constitute a credit event under the CDS. This is because lenders would be agreeing “voluntarily” to subscribe to new debt which would be used to pay off existing or maturing debt. The original debt may not have been “restructured” in legal terms.

This means that, for Greece, only a “hard” default – a failure to pay, full debt rescheduling or non-voluntary or forced exchange – would allow the CDS protection buyer to trigger the contract.

In contrast, the rating agencies have indicated that any such voluntary exchange will be regarded as “selective or restrictive default”. Depending upon the terms of the exchange, the new bonds may trade at prices below par (based on experience of previous such exchanges) reflecting differences between the return demanded by markets relative to the new bond’s economic terms. This will result in investors incurring losses.

Where the CDS was entered into to hedge existing bonds or loans, inability to trigger the contract will mean that investors will not be compensated for any losses on any bonds or loans held. They will also have incurred the cost of hedging for the ineffective CDS contracts. Although the ongoing CDS contract may have some value as insurance against a “hard” restructuring in the future, there will be mismatch between the maturity of the restructured bond and the existing CDS making any benefit contingent on the timing of any default.

Where the CDS was entered into as a pure “bet” on the likelihood of a Greek default, the speculators who bet on there being no “default” will prevail, despite the economic reality of Greece’s “restructuring”.

The final arbiter of whether the Greek CDS has been triggered will be the Determinations Committee (“DC”), set up the industry association International Swap Dealers Association (ISDA), a voluntary body which governs the market. The DC comprises ten bankers and five investors. Unless backed by a supermajority of 12 out of 15 members, its decisions are externally reviewed by a committee of “independent experts”. While perfectly legal, the ability of a private body of financiers and lawyers to determine whether or not there has been “default” is unusual and legally untested.

For banks and investors who entered into CDS to insure against losses from a Greek “default”, the potential failure calls into question its economic effectiveness. As regulators and accountants assumed that the CDS eliminated or minimised risk of losses, the level of capital and reserves set against risk of Greek investment or the accuracy of financial statement may be incorrect.

An instrument where the intended consequences (protection against loss) can be manipulated by using different arrangements, with similar economic outcomes, has questionable utility as a hedge. The fact that an unelected and extra-judicial body of financiers is charged with settling any dispute adds to the problem.

None of these problems are new. The recent history of the CDS market is replete with disputes regarding the entity being hedged, whether there has been a credit event and the quantum of the actual loss suffered.

For example, the restructuring of MBIA also avoided triggering CDS contracts on the firm through the use of reinsurance.

The MBIA restructuring entailed the US municipal underwriting book being reinsured by a new entity – National Public Finance Guarantee Corporation (“NPFGC”). Reinsurance arrangements with FGIC were then ceded to NPFGC. NPFGC also issued second-to-pay policies to all policy holders covered by the assignment giving the beneficiaries a direct claim on the new entity and benefit from the credit quality of the new entity (that may be superior to the pre-existing MBIA). All other businesses including structured finance exposures remained with MBIA.

The arrangements were designed in part to avoid triggering the CDS contracts under the “restructuring” credit event. They were also designed to avoid the succession provisions in the CDS contract that would have required existing CDS contracts where MBIA was a reference entity to be split between MBIA and NPFGC. The effectiveness of the arrangements in not triggering the CDS contracts relied on highly technical readings of the contract specifically the concept of a “qualifying policy” under the Monoline Credit Derivatives Supplement.

The economic result of the arrangements was that MBIA retained the troubled structured finance exposures while losing the profitable and arguably less risky municipal re-insurance business. MBIA also reduced significantly the amount of capital it had available to support the exposures that remained with the firm.

MBIA was subsequently downgraded to non–investment grade. The downgrade reflected a reduction in MBIA’s claim paying capacity, reduced capital, transfer of reserves associated with cession of it’s municipal portfolio and the continued deterioration in the insured portfolio of structured credit assets. This materially increased the risk to sellers of protection in CDS contracts on MBIA. A number of hedge funds launched a class action against MBIA in relation to losses sustained as a result of the restructuring.

The technical nature of the arrangements highlights the potential legal issues present in CDS contracts. Different legal forms of economically similar actions can lead to entirely different outcomes under the CDS contract complicating significantly the effects of the contract and its efficacy as a hedge.

Ultimately, these problems raise a fundamental question: are CDS and, more broadly, derivatives useful and legitimate instruments of risk transfer or (in the words of one FT commentator) nothing “much more than a floating craps game in an alley off Wall Street“.


Satyajit Das is author of Extreme Money: The Masters of the Universe and the Cult of Risk (FT Press, forthcoming August 2011).

A shorter version of this article was published in the Financial Times (23 July 2011).