Guest Post: Greek CDS - Missing The Forest For The Trees

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From Peter Tchir of TF Market Advisors

Greek CDS - Missing The Forest For The Trees

There appears to be growing momentum for a Greek restructuring.  It can be called a reprofiling or soft restructuring or hard restructuring, but in any case it seems that the likelihood of some debt being restructured is fairly high.  The ECB seems most opposed to any restructuring, though more and more, the ECB position, looks like a feeble attempt by Trichet to bury the fact that his open market purchase program has been a total disaster.  The other complication is some misguided attempt to effect a restructuring, while trying to avoid triggering a CDS Credit Event.

Any attempt to specifically avoid triggering a Credit Event is misguided at best, and possibly very damaging to the banking industry the EU finance ministers are trying to protect.

The Greek CDS market is actually fairly small.  According to DTCC, there is only 3.8 billion euro of net CDS exposure on the Hellenic Republic. That compares to almost 300 billion euro of debt outstanding.  There may be some additional exposure to Greece cds since it is included in SOVX, but the Greek portion of net SOVX exposure is very low, and some of the exposure is offset by investors who trade 'cds index arb'.  Not only is the 4 billion euro of exposure relatively small, most of it is held in mark to market accounts, so a lot of the loss to the system is already accounted for.

Not only is the exposure fairly small, as I have argued already, I suspect that CDS at this stage is actually transferring risk out of the banking system and into other areas.  I believe banks are now net short Greek credit via CDS.  Banks will benefit from triggering CDS as they will monetize those gains against losses in their bond portfolios.  The losers from a credit event would be insurance companies and hedge funds as I believe both of those areas are now net sellers of Greek CDS.  At one time, clearly, hedge funds were net short Greek CDS, but with 5 year CDS trading at 25 points up front and 500 running, a lot have taken profits, and some have made the bet that the EU governments would do something stupid, like avoiding a Credit Event. 

If a bank owns 2 years Greek bonds and 2 year CDS they are hedged and would receive regulatory capital relief.  If they are forced to extend their bond but are not allowed to trigger their CDS they have a serious problem.  The bond will decrease in value, because although the Greek yield curve is inverted, the price of front end bonds is much higher than longer dated bonds.  The CDS would gap tighter as no one would want to own CDS in an environment where finance ministers purposely structure around it, so the banks would have a loss on their CDS and a loss on their bond.  Then, adding salt to the wound, they would see a jump in their regulatory capital as the maturity mismatch of their bond vs their CDS would be too great and they could not claim regulatory capital relief from their protection.  This seems like the last thing the governments want.

So the size of the net exposure is fairly small, and if anything, avoiding a credit event is likely to hurt banks more than help them, why are they doing this?  Is it concern that a credit event will scar the reputation of the eurozone?  Maybe the public will be tricked by a reprofiling without a credit event, but the investment community that matters will see right through this.  If anything, the eurozone would lose credibility by trying to play word games and spending so much time trying to violate the credit derivative market. 

Since the net exposure is small, banks are likely beneficiaries of a credit event, and markets will see through this feeble attempt at avoiding the stigma of a default, the EU finance ministers should stop worrying about how a restructuring will impact CDS.  They should focus on restructuring in a way that provides the best possible outcome for Greece and creditors and not worry about what happens in the CDS market as a result.  If after sorting out the Greek situation, they still have time to think about CDS, they should spend that time figuring out who sold the protection and why?  For every evil, vile, nasty, hedge fund who had bought credit protection, someone took they other side and sold protection?  If the purchasers are so evil, does that make the sellers angelic?  The ECB shouldn't vilify a product but they should figure out why the sellers exist and if they want to revise the market over time, they should examine that side of the market as closely as they examine the buyers of protection.  And once again, I think any bank that holds greek bonds in a non mark to market account and is still a net seller of Greek CDS should receive close scrutiny from its regulator.