Early yesterday morning, word trickled out that a new "comprehensive" deal to "fix" the euro-debt crisis had been cemented. Investors in Europe and abroad were thrilled; markets rallied an average of 3%. Analysts were less enthusiastic, somehow universally agreeing to use the term "cautious-optimism" to qualify the deal. While the media and analysts are still digesting the hard data (many in the negotiations were quoted saying they had trouble understanding many of the components of the deal), a few things are certain. Greek debt holders will take a 50% haircut on the face value of their paper (much more than previously agreed upon this summer), banks will have to raise their tier-1 capital to 9% of the banks' holdings, and the EFSF will be leveraged to a total of 1.4 trillion euros to meet all previous obligations without being totally zapped.
While this is indeed great news (primarily because we now know the EU has come to their senses and will not expect Greece to fully pay all of its unrealistic debt), many details remain to be determined. One particularly interesting detail yet to be negotiated is the fate of credit-default swaps (CDSs) on the Greek bonds. The EU deal has chosen to classify the 50% haircut as a "voluntary" write-down. While these losses are, in reality, far from voluntary, the deal is trying desperately to avoid a "credit event" that would trigger pay-outs of the CDSs. However, if this massive write-down isn't a "credit event", despite the fact that it is clearly a default (albeit an "orderly" default), what the heck is? With the EU saying the nearly 4 billion euros worth of CDSs purchased on Greek bonds wont be triggered (think your fire insurance refusing to pay because only half of your house burnt down), this will, in my opinion, trigger a credit-event of a different kind. The liquidity of the CDSs market will all but disappear, at least on sovereign paper. What would make sense, at least to me (and we all know I am more of the outsider-looking-in than any kind of real expert), would be for the CDSs to pay out what is written down. That was the original intention of the CDSs in the first place, to insure against losses of any kind. In theory, the sellers of swaps should not be all that surprised that Greece is defaulting, and should have more than enough cash to cover half of the losses. The risk of default, when calculated accurately, should be reflected in the price of the CDSs. I have a hard time believing that banks (or whoever originated the CDSs, or later bought the puts) would sell a Greek bond swap at the same rate as a US swap. And they didn't. The International Swaps and Derivatives Association would be far better suited to NOT bend to the will of the EU, and declare the haircut a credit event, therefore triggering payouts. After all, the negative implications on future derivatives markets should be of much bigger concern to the association in charge of it than a puny €2 billion, since the default was only on 50% face value). For the sake of the future of swaps and derivatives (at least on sovereign debt), I hope the ISDA holds firm.
(sources: The Economist)
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