Monday, January 23, 2012



This post is genuinely more of a question than a comment; only a little of my oft-used disingenuousness went into the generation of this post.

Now that the disclaimer is out of the way, here is my somewhat rhetorical question: If I am a Greek private creditor and I have protected myself with credit default swaps (“CDS”), what is my incentive to go along with a “voluntary” debt exchange that involves drastically reducing my coupon and face value and probably equally drastically extending my maturities, resulting in, at the very least, a halving of the net present value of my bonds? Why not just force a default, a resultant “credit event” (See my 6/8/11 post, A TRAGEDY WORTHY OF AESCHYLUS.) and collect on my CDS position? If my implied logic is correct here, why aren’t the parties short the protection on the CDS contract involved in the negotiations rather than the parties long the protection on those contracts?

I can think of a few answers to my query. First, and understandably, the creditors, whether protected or not, are under tremendous pressure to reach some kind of accommodation with the Greek government “for the good of the financial system,” or some other such drivel. But surely there are some among the holders of the debt, even if those holders are European banks, who, unlike the people who run the major banks in this country, have the courage to stand up for their shareholders, and other stakeholders rather than buckle under government, or international pressure.

Second, those protected by CDS positions may have little confidence in the ability of their counterparties to make good on their contracts. But if that is the case, why would the creditors enter into such expensive contracts in the first place? Perhaps the creditors’ lack of confidence is a lack of confidence in their counterparties only in the wake of the general confusion, and possible chaos, that would follow a Greek default.

Third, perhaps the creditors have little confidence in the legal solidity of their CDS contracts in the wake of those creditors’ passing on an opportunity for a “voluntary” settlement of their Greek debts. Again, though, why enter into the contracts in the first place if you have little confidence in them?

Fourth, perhaps my implication is correct and those with CDS coverage have little incentive to negotiate, but there are few creditors who have purchased such coverage. If that is the case, though, the problem of a Greek default is overstated; note that aforementioned 6/8/11 post, A TRAGEDY WORTHY OF AESCHYLUS, in which I state one of the reasons that the Eurocrats are so intent on averting a Greek default is because of a credit event’s repercussions for the CDS market and, consequently, for the European banking system.

There is a fifth possibility; maybe I am absolutely right that those who are long CDS protection have no incentive to negotiate and that is why the negotiations are going so slowly.

Perhaps the larger point here is what the ramifications of the entire Greek episode are for the CDS market. If, somehow, a “voluntary” debt reduction is forced down the throats of creditors, rendering them unable to collect on their CDS bets, one has to wonder why one would ever want to avail one’s self of such protection, at least for sovereign debt; i.e., if the system can always be jimmied so that no one has to make good on the short side of a CDS bet, why would anyone want to be on the long side of such a bet? Extending, why have a CDS market at all? Extending further, without a CDS market, how much more expensive will financing become for borrowers with even moderate credit issues?

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