WSJ: Danger if Greek CDS aren't triggered

[Xisiqomelir]

Another Murdoch Rag

CTOBER 27, 2011, 6:06 P.M. ET
Dangers Lie Around Corner If Greek CDS Aren't Triggered

--Greek CDS unlikely to be triggered for payouts with voluntary deal

--That hurts integrity of CDS as a hedge and may diminish usage

--Fallout will be higher borrowing costs for sovereigns, say observers


By Katy Burne
Of DOW JONES NEWSWIRES

NEW YORK (Dow Jones)--While markets rallied Thursday on news of a deal to stem Europe's debt crisis, adverse consequences of the deal lurk in the background.

Investors' focus has turned from the deal itself -- in which some private investors will take a voluntary 50% write-down on the notional amount of sovereign Greek bonds -- to the potential lack of payouts on insurance covering losses on sovereign debt and its impact on markets.

The legal uncertainty over payouts on credit default swaps could obviate the value of sovereign CDS -- a $2.5 trillion market -- and endanger those firms that have been relying on the contracts to hedge declines in their European holdings. Banks that use credit-default swaps to hedge their government bond holdings may be forced to find other ways to lay off risk.

It also helps explain why CDS tied to bank debt took a beating in recent months, as market participants sought proxy hedges in case their CDS didn't pay out and policymakers in Europe sought to ban "naked CDS," where firms own a CDS but have no bond exposure, and thus no insurable interest.

There were reasons why European bank debt needed to be re-priced to reflect its greater risk, but the panic over CDS contributed significantly to the negative price action on banks, said Adam Fisher, chief investment officer at hedge fund Commonwealth Opportunity Master Fund Ltd, and a trader of sovereign CDS.

"Officials inadvertently put bank debt in the line of fire," he said. "They screwed the CDS and people had to go and find something else, and when everyone did that at the same time, it crushed bank stocks."

Eventually, investors may realize that since it is so hard to get CDS to trigger payouts on a restructuring, without a hard default, that it might not be a reliable hedge. Typically, a decline in bond prices is married to a rise in risk premiums in CDS, so the insurance contract becomes more valuable as the securities they are covering become more distressed. If risk-spreads, CDS don't widen much and people don't buy the coverage, and over time it could wither and die.

The net volume of Greek CDS has fallen 5.2% over the last four months, and is down 48% from this time a year ago, according to the Depository Trust & Clearing Corp., which tracks 98% of CDS positions.

"You need the real-money guys, the banks, to view that as a viable contract for CDS to be a real market," Fisher said. "I'd argue the size of the market will shrink, liquidity will dry up and bid/offer spreads will diverge to a point where you kill off the market."

Moreover, toying with the CDS market in the hopes of saving sovereigns from default by European policymakers may leave investors so devoid of hedging options that they dump sovereign bonds altogether. Without banks and hedge funds buying sovereign paper, the European Central Bank will be forced to have an increasing role in helping countries fund themselves, contrary to the natural order of markets.

Some opportunists may be incentivized to sell CDS protection on European sovereigns, believing the risk of officials letting them default to be low. But if the CDS is gradually considered to be less trustworthy, it's something they can only profit from for so long because appetite from buyers may dwindle.

The greater likelihood is that investors will sell out of sovereign bonds -- not just Greece, but Italy and others -- and unwind their protection contracts to diminish their exposures from every angle.

"If you owned a sovereign bond and you got scared because you bought CDS thinking it would pay out, you'll realize you would have been better off just selling your bond-and you'll just get rid of everything," said Ashish Shah, co-head of credit at Alliance Bernstein.

Shawn Stoval, managing partner at San Francisco hedge fund Varden Pacific, said it will raise borrowing costs for sovereigns because the lack of integrity in CDS will "reduce incremental demand" among non-bank buyers and "it will give people pause before buying."

The agreement reached Wednesday night should allow Greece to cut in half the EUR205 billion ($290 billion) of its debt held by private creditors, but while the deal was said to be entered into voluntarily, many observers believe there was an element of coercion involved. This would be significant because it would qualify holders of sovereign CDS for payouts. Payouts won't likely be made so long as the deal is voluntary, according to the International Swaps and Derivatives Association, although the association's credit derivatives definitions do not describe what it considers voluntary to be.

Banks hold a significant portion of Greek bonds, and the agreement announced by the Institute of International Finance was reached after investors agreed to a 50% write-down or "haircut" on Greek debt through an exchange of old bonds for new ones.

A major incentive for those investors, who in July had already agreed to a 21% haircut, was the $1.4 trillion recapitalization of certain financial institutions under Europe's rescue plan, something that might be considered coercion.

"While voluntary is what Europeans want, the deal last night was voluntary at the point of a gun," Peter Boockvar, equity strategist at Miller Tabak + Co. wrote in a note Thursday.

The issue is expected to be a thorny one when a special ISDA committee is asked to rule on whether payouts can be made on Greek CDS after the debt exchange is complete.

Banks may have called the deal voluntary, but so long as there is a single debt owner who was given the option to hold out and did so, ISDA will have a hard time saying the deal was mandatory and justifying payouts on the $3.7 billion of Greek CDS outstanding.

-By Katy Burne, Dow Jones Newswires; 212-416-3084; katy.burne@dowjones.com

The Journal is being euphemistic here. "Higher borrowing costs" = "Skyrocketing yields" = "Euro Sovvy Collapse". Consider this, with CDS neutered and shorting banned, there's only one way left to reduce your exposure, the old-fashioned way: selling out. And though everyone seems to hate short-sellers and blame them for this entirely bull-manufactured collapse, who will be there to cushion collapsing markets when people can't even buy to cover?