Any Greek Restructuring Should Be Designed To Trigger A Credit Event

Tyler Durden's picture

From Peter Tchir of TF Market Advisors

Any Greek Restructuring Should Be Designed To Trigger A Credit Event

As talk about an actual restructuring of Greek debt increases, the EU continues to think avoiding a CDS Credit Event is a good thing.  More and more stories and leaks indicate that a real restructuring of Greek debt is on the table, with write-offs of as much as 50%.  Whether it will be real, permanent reductions in principle this time, or some other form of principle protected rollover with a subjective NPV calculation like the 21% haircut, remains to be seen.  In any case, the EU continues to head down the path of bending over backwards to avoid trigger a CDS Credit Event.

They are wrong to be avoiding a Credit Event on the Hellenic Republic.  If they are really pushing for a true restructuring where banks and insurance companies are for all intents and purposes forced to accept a big haircut, they should want to trigger a CDS Credit Event.  They are allegedly avoiding a credit event because it “could unleash a cascade of losses” according to a bloomberg article.  That just makes no sense.  It also seems that pride plays a role as the EU doesn’t want to be impacted by the stigma of a default – a 50% write-off is even, but they don’t want to be called defaulters.  That is plain silly.  They also seem to want to punish speculators, and this is where they really have it wrong, not only are few hedge funds short Greece via CDS at this time, the problems this creates for bank risk management desks is big and will have long term negative consequences for sovereign debt demand.

Bank Credit Risk Management Back to the Dark Ages

JP Morgan is one of the few institutions that have come through the financial crisis with an enhanced reputation.  Their skill for
managing through the problems has been clear and the respect for the firm and Mr. Dimon in particular has grown.  It is their risk management that has been a key to their success.  On their earnings call they were able to point to low “net” exposure to Europe.  They had “Portfolio hedging” for their European exposures of $5.2 billion, 80% of which was related to sovereigns.  So it is possible that JPM was short about $4.2 billion of sovereign CDS to manage their overall exposure to Europe.  If the regulators can pressure banks into taking big write-downs on their positions and make their CDS ineffective, how long before Mr. Dimon realizes he has to do something else to manage his exposure.

If buying CDS is unlikely to provide the relief it should, the only way to reduce economic exposure is to sell assets.  JPM would likely be ahead of the curve and sell their CDS while it still had value, and sell bonds/loans at the same time.  Other banks and investors will eventually realize that they cannot rely on “net” exposures, when the regulators corrupt the product.  Investors will start to focus on gross exposures because they will doubt the ability of banks to ever monetize their hedges.  All the big banks, still likely to be risk averse, even after some multi trillion euro EFSF announcement, will want to maintain low economic exposure to European sovereign debt.  If they don’t believe their hedges will protect them because they would once again be forced to write down assets and not collect on their hedge, the only prudent risk management decision is to reduce assets.

By eliminating a tool for banks to hedge their exposure by blatantly working around it, the EU will reduce future demand for bonds.  Not what they are trying to accomplish.  The whole point of the EFSF and other programs is to stimulate demand for bonds, and they will have achieved the opposite as big banks will have to reduce bond holdings since they will realize they cannot rely on their hedges.

At the other extreme, some weak banks, the ones who likely wrote CDS rather than buying bonds because of the leverage, will want to write even more CDS.  Why would they ever want to buy bonds when the EU just taught them that selling CDS is “free money.”  The weaker the institution, the more appealing that trade will be.  So in the future, the unregulated, difficult to track CDS risk, will all be the hands of the weakest institutions – again, a result that does nothing good in the long run.

The Facts Do Not Show a Risk of “Cascading Losses” From a CDS Credit Event on Greece

According to DTCC, the net Hellenic Republic exposure in the entire system is €2.7 billion.  Yes, the open longs (or open shorts) are a total of €2.7 billion.  That is trivial compared to the €330 billion or so of Greek bonds outstanding.  It isn’t even 1% of the exposure the system has via the bond market.  With a 50% haircut, bond investors will lose about €165 billion, and in the CDS market, a total of €1.3 billion would find its way from the net sellers of protection to the net buyers of protection.  If the regulators and EU are sure the system can handle the bond write-offs, the write-offs for CDS are a rounding error, at best.

What about the “transfer mechanism”?  Isn’t there some way the chain of payments could break down?  There gross notional for Hellenic Republic CDS is €54 billion.  These represent a combination of things, but primarily dealer to dealer trades where one dealer has an ultimate seller, and the other dealer has an ultimate buyer, and the trades run through them since they either don’t fact that client or weren’t the “axe” at the time the client was putting on the trade.  There are also curve trades.  Curve trades will collapse down. The street will run “trioptima” or some equivalent to net the risks down.  Banks are well prepared for the settlement of CDS.  The settlement of Lehman went smoothly in spite of concern at the time.  There is no reason to expect it not to go smoothly this time.  Once again, JPM’s quarterly Earnings Presentation has some useful insights.  They have $8.2 billion of Trading Exposure to Europe, which is “predominantly client-driven derivatives exposure of $14.2 billion, offset by collateral of $6.7 billion (95%+ held in cash).”  I’m willing to assume that JPM is doing a good job on their counterparty risk management.  Other big banks are going to be very similar.

But let’s look at a worst case.  Assume one bank (“Dumb Bank”) has written the entire €2.7 billion of net outstanding Greek CDS.  That bank then owes €1.3 billion.  If the bank doesn’t have the money to pay, they would not pay the money to whoever they sold the protection to.  They would have sold it to one of the “Dealer” banks, one of the 20-30 biggest banks that make markets in CDS as part of their core fixed income platforms.  If they had trades on with several bank, then each of those banks would take a loss.  It would not change their obligation to pay on their contracts?  Does anyone really believe that one of the big banks couldn’t afford that €1.3 billion loss?  It would be painful, but they would absorb it, and the rest of the payments would flow through the system.  They would honor obligation to whoever they sold CDS to, in spite of not receiving the money.  That is how the system works.  The extreme example where one bank provided that much counterparty exposure to one institution that couldn’t pay would is unrealistic, but at least from the CDS chain of events, the losses would end at the big bank(s) that made that decision.  No Contagion.

The Dealer Bank would then proceed against Dumb Bank to collect its claim.  Dumb Bank would enter into bankruptcy in some form or another.  Bondholders would have a loss, and Dumb Bank’s other counterparties would all have to scramble to replace risk.  So this does have the potential to create contagion, but is the market really so stupid that no one would have noticed how bad Dumb Bank’s finances were?  The debt wouldn’t be trading anywhere close to par if the bank had such big exposures and was in that much trouble.  The loss to any single bank from triggering CDS is not likely to be enough to force them into bankruptcy.  Unless a bank has been able to hide massive exposures from the market neither the share price nor the debt of these banks should be significantly affected by monetizing a mark to market loss already priced in, and in many cases, already collateralized.

The system is just not that fragile, and the possible payments from triggering CDS are negligible relative to the losses that will be experienced from the bond market write-downs.  If the EU believes the financial system can handle writing down the €330 billion of bonds (and I believe it can), then it is highly unlikely that the additional losses on €2.7 billion of CDS will be the straw that breaks the camel’s back.  It is just not plausible as the number is small, and the counterparty risk management is actually pretty good, and this would require gross negligence in virtually each and every bank to trigger the contagion risk the EU seems to fear.

Pride and Punishment

An actual restructuring where financial institutions permanently write-off 50% of the principle owed is a default by any other name.  Pretending it isn’t a default so you can say you have never defaulted is just bizarre.  The loss can be called anything you want, but the end result is the same.  Worrying about the semantics of having had a CDS Credit Event is just absurd.  You can say that you “are slightly above ideal weight” but people will still no you are fat.

And who is getting punished?  Reading between the lines, the EU seems to be licking their chops at punishing all the hedge fund speculators who are short Greece via CDS.  Well, guess what?  They are NOT short Greek CDS anymore.  The hedge funds are now generally flat or even long Greece via CDS.  All you need to do is think about it for a moment.    Greece trades at 62 points up front.  So on a $10 million trade, you pay or receive $6.2 million.  If you felt governments weren’t going to manipulate the situation, where would you think the CDS would trade after a Credit Event?  What is the recovery rate then?  I think assuming anything lower than 20% is extremely aggressive.  So you are risking 62 to make 18?  That would require a high degree of certainty, or an even lower recovery assumption.  It would also require you not to have read a newspaper or turned on the TV for the past month.  The G-20, the IMF, the EU, the ECB, are all lined up to try and prevent a default, and even more importantly, continue to state that they want to avoid triggering a CDS Credit Event.  You are making a bet against their ability to circumvent the rules.  From a risk/reward standpoint, I would not be short Greek CDS.  If anything I would have sold Greece CDS here (especially with talk of a 50% settlement).  I would much rather be short French or Belgium CDS.  They have a lot more opportunity to widen, with a limited ability to tighten.

But if hedge funds aren’t short Greek CDS, who is?  Bank hedging desks!  The banks are net short.  The banks do not want to take off their shorts because they don’t want to report larger net exposures.  They aren’t taking profits on these because optically they cannot report to shareholders increased exposure to Greece.  They have done the same analysis as hedge funds and would like to cut their shorts, but this isn’t about making money for the banks anymore, this is about presenting low exposure numbers.  The smart, hedged banks, will be the ones punished.  The EU wants to punish the hedge funds, but all they will do is punish banks that have been most prudent.

And who is rewarded?  Good old dumb bank.  Wrote some CDS because they could get more leverage, and here they are being rewarded by the EU.  The efforts to punish are likely to punish the wrong people and further reward the weakest institutions.  At one time hedge funds were short Greece via CDS, but at one time I was young and athletic – things change over time.  The EU should get over their anger and think responsibly.  That is the only way to truly start correcting the core of the problems.  Lashing out by manipulating markets and rules will do more harm than good.

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Fips_OnTheSpot's picture

How long can a can be kicked?

G-R-U-N-T's picture

"How long can a can be kicked?"

Vengeance is mine sayeth the CAN as the road ends and woe to the can kickers as you will have my wrath!!!

max2205's picture

Why the fuck would the writer believe anything that non mark to market JPM would say on an earnings call. 150% of their 'earnings ' in the last Q where from taking their drop in JPM bonds up to the earnings line

What a bunch of crap. CDS 's WILL EXPLODE!!!!!

sqz's picture

This is a badly written article. Tchir's intent comes across but it reads like garbage to anyone who works in the markets or seriously follows it. It must be a bit of a nightmare to understand for someone new to credit markets.

1. Guy keeps mixing up "short" CDS (i.e. short protection, long credit) with short Greece (i.e. short credit, long protection) and talking about "sold" and "selling" when he means unwind or closing.

2. Anyone who would call JPM ahead of the curve in risk management immediately after they just posted earnings, where more than 27% of it is from their DVA (i.e. extremely controversial booked profits due to losses on your own debt) and that this specifically enabled them to beat their expected earnings, is very deluded or trying to sell some agenda.

3. He critically misunderstands that the primary reason some members of the EU wish to avoid default is due to the seniority of debt and past payouts from the "official" creditors, i.e. IMF, ECB, and bilateral EU gov. funding (and presumably the new crisis funds ESM, EFSF). In fact, you can pretty much boil it down to the ECB being the main blocking point. Unlike the IMF they didn't hand out special loans to Greece, but instead under Trichet (with huge internal controversy especially from the German central bankers) bought Greek debt on the open market like anyone else. This gives little reason for them to be afforded special protection from haircuts or outright default on Greek bonds.

To the ECB, taking a loss on Greek debt is like a bomb going off in their books. It is arguably even worse than if it had happened to the IMF because it is a central bank. Not only are they likely to have to go ask all the EZ governments for money (assuming no asset liquidations like gold ;p), but it creates a precedent and tarnishes their reputation for future crises.

In addition, EU gov. funding to Greece in the past has had no senority over private creditors, this means that if Greek did default again there is no reason why they should be excluded from the losses. This is a significant politcal risk since now they would have to return to their taxpayers and declare they lost money on Greece and, oh look, time to fill yet another budget hole - can anyone donate their first child, etc.

At the rate Greece is bailed out from all official corners of the EU and the rapidly diminishing contribution of private creditors to Greek debt holdings, at some point it will become easier for governments to keep talking up the crisis and just keep bailing out Greece with emergency loans (who knows where from) for years, than it is to even contemplate a loss on their existing payouts.

What's ironic is that if you actually look at the figures, without all this interference, Greece would need to repudiate its outstanding debt completely (while retaining the ability to recapitalize its banks) in order to achieve an actual reduction on their total debt. Due to the mixing of official creditors with private creditors, mainly due to the ECB, it's in Greece's interest not to do anything at all but just wait for the money to come in drips.

That is, to hell with moral hazard, ECB/EU wants to save its reputation at almost any cost to their taxpayers.

Lord Welligton's picture

Well argued.

However I would disagree on a "continuing crisis" and endless drip-feed to Greece.

I think things will come to a head before long.

It's one thing for King Canute to claim he can hold back the sea.

It is an entirely different matter to put it into practise.

falak pema's picture

well when poseidon becomes angry it ends up in tsunami. Even in the Medit. So its worth meditating.

spdrdr's picture

Canute never claimed to be able to hold back the sea.

He famously demonstrated this to his many followers (who thought he was a god), by ordering the incoming tide to cease - and failed miserably.

Lord Welligton's picture

I was aware of that at the time of writing.

I was using the common knowledge of Canute.


Drawing the myth truth out ........

Who will be Canute today?

Who will say that the tide is running out on the West?

Who will lead like Canute?


oogs66's picture

It seems that Europeans like to talk about CDS in terms of protection so long or bought means short credit risk. Americans tend to talk about it in terms of risk - so long or bought means long credit risk. Another added level of confusion to this product.

Ghordius's picture

Yes - Investing vs Betting mindset


Take the live grenade from those juvenile's tentacles.

Lord Welligton's picture

Or leave the grenade with the juvenile's testicles.

falun bong's picture

and in principle you should spell principal the right way

disabledvet's picture

I disagree totally with this article being a piece of garbage. To me it makes perfect sense: "the problem is that the banks are" (as they always are) "net long." This is the whole basis for Credit Default Swaps. Before this item was created simply put there was no insurance for financial entities that have been scaled up to manage their risk. The hedged risk vis a vis Greece...and i imagine all the other nations of Europe (relative to the risk) is without a doubt so small as to be a rounding error relative to the net long exposure. In short "the countries are destroying their banks" which given the size of the financial system relative to actual nations does in fact put the individual nations at risk (riots in the street)....whereas in the USA the interest is only in nationalizing them apparently. Anywho "Europe's up first." Perhaps the member States of the EU are just trying to "cut their banks down to size" (maybe the elected leaders are just trying to run their countries?) but as is obvious these actions have meant "cutting your country down to size." Since no one wants the benefit cuts in each of the member states of the EU it all comes down to recognizing the the fact the entirety of the European Banking sector has a net long exposure and not as it presented in the MSM "mere exposure" at all. In other words this isn't "kicking the can down the road" at all but in fact simply being in denial--or worse. Since all we need to do in our analysis is "simply see what the people in The Street are doing as a conesquence" we can simply dispense with the ridiculous argument of mere "moral hazard" as presented above. This is SECURITY HAZARD...and not a mere moral one. Insofar as "the currency rises in value as country so and so explodes in an orgy of violence"....well, "that must be those little countries." Again...we shall see what the consequences of the now global movement now known as "The Occupation" truly is. When the media starts "complaining" that "anarchists" are "hijacking the movement"...well, let's just say it sounds rather American. Hard to imagine "it all started with a unemployed fruit vendor." Amazing.

Sam Clemons's picture

The energy stats don't lie.  The can kicking is clearly not working in the real world.

For those of you who liked my energy, historical bull market charts, I updated them for the first time in months.  Also have some info on where we are headed in the short term.

agent default's picture

Greece should default big, should default loud, and should tell the Eurocrats to shove it.  I do not understand why the decision fo weather to default or not, is not something for Greece to decide, but something for the EU.  This is nonsense of  the highest degree.

Divine Wind's picture

I think Greece has given up this right with prior rounds of funding.

Threat Journal recently carried a video with Max Keiser that explains much of it. Incredible.



And behind it all?  Goldman Sachs.

Lord Welligton's picture

And this from the traitor Papandreou.

"We are not Atlas which can take all Europe's problems on his shoulders," he said, referring to a Greek mythological figure who supported the heavens on his shoulders. "If Europe cannot solve its problems, the consequences will be unpredictable for all of us in Europe."


DosZap's picture

agent default

Reason?,easy...................................FREE CHIT.

Suck that teat as long as it puts out. Greece(and several others are) basically WELFARE soverigns.

Who the hell wants to have to do it thereself.When they can get it free.


Ghordius's picture

It's the biggest of the world
and it's called NATO

holdbuysell's picture

The complexity of the system is ridiculous. These jackwagons have wrapped themselves around the axle so tightly, there's no more room to move.


Rainman's picture

Profit from failure is a grimy, unethical and immoral business. And business has never been better.

rocker's picture

That is why Goldman always wins. Throughout the summer they took trillions out of the market.

 Now people are leaving in mass.

So Goldan and their special algo manipulating software is taking the maket up to attract new money in.

Hence, Rinse and Repeat. Just went they suck in enough money again. The Squid will suck it out again.

There is no more proof for me that Goldman Rules the World as the BBC guest said.

When Greece had their Riots they had banners with Goldman Sachs on them all over the place.

That is not something that was a illusion, it was reality that Goldman is in part to blame for the people's downfall.

It is terrible of CNBC to leave people under the impression that the Bailout of Greece was for the people.

It is not, the bailout would be mostly for the bond holders. bond holders mostly being the Banks and the elite who

control the banks.  Dam, it's always the banks.

JohnG's picture

Said one lawyer to another?

falak pema's picture

If greece had patriotic leaders it would default loud and clear. Let Eu handle its banking fall out. Unfortunately, Greece has Oligarchs, part of Euro construct. Paid shills who lied then as they lie today and let their people pay to save their banker friends.

bank guy in Brussels's picture

Peter Tchir writes above:

« ... Dumb Bank would enter into bankruptcy in some form or another ... »

Dumb Bank - I think many of us have had an account there at some point ...

dasein211's picture

Theyre scared to death because they know that the off market dark pool derivatives would crush everything. Its not what we see in the open. Its whats under the sheets. There is no other explanation. With what we know in the open it makes sense to mark it all down and take the loss but theyre hiding a derivatives nuke that will take out everyone and they know it... Or a few know it and are trying anything to stop it.

agent default's picture

This is not Greece's problem. It's their problem.  Greece should tell thm to fuck off.

CrashisOptimistic's picture

DTCC is not comprehensive anywhere and certainly not in Europe.

oogs66's picture

why the hell isn't this stuff on an exchange yet?  really it is getting close to 4 years since Bear and this huge product, is still completely hidden....insane!  regulatory failure...complete regulatory failure, but hey, we can do operation twist - what a joke :D

Mike2756's picture

'Cause they fought it. No market for that garbage or, was it something else?

Absalon's picture

The market in interest rate swaps is so totally disproportionate to the amount of hedgeable debt outstanding that most of the swaps are probably being used for some inappropriate purpose - probably tax avoidance - and creating systemic risks as a side effect.

kaiserhoff's picture

Good point.  Ditto for the volume in FX transactions.  Barrons got their panties in a knot over this for a while.  Speculation was that much of it was money laundering from crooks and cartels.  No one seems to want to look too closely. 

Manipulism's picture

For example Ackermann knows it for shure.

end da fed's picture

please help me understand derivatives...

kaiserhoff's picture

Start with any well written book on stock options: puts, calls, basic strategies.

Don't try to deal with bonds unless you want to be a specialist or a drooling, muttering nincompoop like the rest of us;)

CrashisOptimistic's picture

Worshipping at the altar of DTCC's measurements of CDS exposure is a particularly bad idea, especially for European insurance, which may not clear through DTCC.

dvp's picture

Fascinating is the article's passage, "a true restructuring where banks and insurance companies are for all intents and purposes forced to accept a big haircut."  "Haircut" appears to be the term du jour in the popular "economics, business, finance" media.  Exactly what does it mean?  Does it mean what it meant during the "terror" in the French revolution?  Now those were "haircuts!"

oogs66's picture

the 21% number they kick around the first time was a pack of lies...the banks were going to keep booking it at par and greece still owed all the money, just over a longer period.  every plan is conceived to deceive

Mike2756's picture

It's more than that, you're talking pension funds, etc.

Zero Debt's picture

How about "take a massive loss on a lousy sucker's bet gone bad"? But wait that is not doubleplusgoodspeech..

Market Efficiency Romantic's picture

Doesn't it look like an inofficial European assessment of net CDS issuance? If US banks were the issuer of Greek sovereign and bank CDS, the EU would take cracks to its reputation but would sure agree to let default. Maybe, European CDS writing on Greece has been more active than generally anticipated, demanding a non-evenmt default. But then again, especially for the large banks, aka Deutsche, SocGen etc, Greek exposure had always been netted of CDS protection. Without protection, their situation would sure look vastly different from what anyone including EBA expects.

Lord Welligton's picture

There are those who say the derivatives are a zero sum game.

They are correct as long as all of the counterparties can meet their liabilities.

But it doesn’t take much for the entire market to implode.

@ $600 Trillion if only .1% fail to meet their obligations that is $600bn.

@ $600 Trillion if only .05% fail to meet their obligations that is $300bn.


Market Efficiency Romantic's picture

I would look at if from a little differerent perspective, however with the same fatal result:

The majority of the 600T are IR swaps, not being influenced directly. And even in the CDS market, only a portion is issued to Eurpean sovereign and Eurpean banks. However, let the relevant market be 20T, if one core column drops, the entire pyrimad drops, eventually also pulling the columns in other derivative markets.

My argument has been, bank recapitalization does not change anything material, as a crack in the derivative chain will despite any recapitalization take down the entire house of cards. I am really wondering, how G20 governments possibly think to safe a derivative chain reaction.

oogs66's picture

if one core dumps, just like lehman, it will be losses on bonds that crush the system, not the guess we just never let anyone default - world is insane....

Lord Welligton's picture

But it is the existence of CDS that allows banks and insurance companies ignore the scale of the losses.

If the CDS market is shown to be less than robust a lot of balance sheets will have to take a hit.

oogs66's picture

yes the system is convoluted beyond recognition and the reluctance to force it on to an exchange or in the open is basically criminal...such an important part of the market remains opaque and feeds the fear and greed causing too much volatility...the solution - exchange - is so simple and beneficial it is just amazing that still nothing done...

Lord Welligton's picture

I agree. A transparent market would help price discovery.

But I'm not holding my breath.

In the meantime we have absolutely no idea how the banks and insurance companies arrive at the valuation of derivatives on their balance sheets.