Guest Post: Credit Events And The Lire

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From Peter Tchir of TF Market Advisors

Credit Events And The Lire

We seem to be finally getting to a point where we may get a real Credit Event for CDS contracts with Greece.  Over the past few months, we have learned that any “Restructuring” is voluntary no matter how much it is coerced from the participants.  Now that Greece looks likely to trigger a Credit Event with a good old fashioned Failure to Pay, we are seeing CDS well bid across the board on sovereign debt.

I would avoid buying protection on Italy.  I don’t think Italy will do well, but I believe that they are most likely to take actions that makes their CDS useless.  I have included (without permission, the Restructuring Definition from the 2003 ISDA Credit Derivatives Definitions).  The scenario that I could see playing out, is that Italy could officially adopt the Lire as legal tender.  If they paid all their interest and principal back in Lire it would not be a Credit Event.  A few other countries could use this loophole, but I see Italy as being the most likely, and the one that would have the most pain for the CDS market.

For a Restructuring to Credit Event it has to meet some conditions.  We have already been made to understand that anything that is “voluntary” is not a Credit Event.  So if investors agreed to be paid back in another currency, it wouldn’t be a Credit Event in any case.  But let’s just assume that with the bigger countries, some investors will resist any “voluntary” program.  Then for a Restructuring Credit Event to occur, either the interest rate has to be lowered, some debt has to be forgiven, the maturity of the debt has to be extended, or the debt has to be changed to something other than a Permitted Currency.

It is the Permitted Currency clause that would allow a country like Italy to keep all the terms of bonds the same, but pay back in Lire, and not trigger a CDS Credit Event.  Permitted Currency includes the legal tender of any G-7 country.  Germany and France could also play this game, but they have spent so much time defending the Euro they seem the least likely to do it.  Italy on the other hand would welcome a weak lire.  They could stop worrying about austerity and focus on getting a Ferrari in every garage in the Hamptons.  Seriously, the Italian economy could perform extremely well if they revert back to making Lire legal tender (note, it does not say it has to be the only legal tender of a country, just that it has to be legal tender, so Italy could continue to use Euro while it re-introduces the Lire). 

The pain on being short Italian CDS on a trade like this could be immense.  CDS is currently trading at 500 bps.  It could tighten 100’s of bps since Italy would now be able to print their way out of the problem.  Even worse, the CDS is denominated in $’s.  If the $ strengthens on the back of Italy leaving the Euro (a likely short term reaction), then the losses are amplified. 

The basis trade could be particularly painful.  Italian bonds would be more likely to get paid off, but the first reaction is likely for bonds to trade down.  It is unrealistic to expect Lire denominated bonds to have the same coupon as bonds denominated in Euro’s.  The bonds would drop in price and the CDS would tighten.  Massive pain for basis traders.

Of all the countries, it seems safer to secure a borrow on Italian bonds and short them, rather than buying CDS.  The scenario described may be unlikely, but I think there is a real chance, and given the size of the Italian bond market, it is well worth the effort to focus on getting a good short on the bonds rather than trading it via CDS.

Section 4.7. Restructuring.

(a) "Restructuring" means that, with respect to one or more Obligations and in relation to an
aggregate amount of not less than the Default Requirement, any one or more of the following events
occurs in a form that binds all holders of such Obligation, is agreed between the Reference Entity or a
Governmental Authority and a sufficient number of holders of such Obligation to bind all holders of the
Obligation or is announced (or otherwise decreed) by a Reference Entity or a Governmental Authority in
a form that binds all holders of such Obligation, and such event is not expressly provided for under the
terms of such Obligation in effect as of the later of (i) the Credit Event Backstop Date and (ii) the date as
of which such Obligation is issued or incurred:

(i) a reduction in the rate or amount of interest payable or the amount of scheduled
interest accruals;

(ii) a reduction in the amount of principal or premium payable at maturity or at
scheduled redemption dates;

(iii) a postponement or other deferral of a date or dates for either (A) the payment or
accrual of interest or (B) the payment of principal or premium;

(iv) a change in the ranking in priority of payment of any Obligation, causing the
Subordination of such Obligation to any other Obligation; or

 (v) any change in the currency or composition of any payment of interest or principal
to any currency which is not a Permitted Currency.

(A) "Permitted Currency" means (1) the legal tender of any Group of 7
country (or any country that becomes a member of the Group of 7 if such Group of 7
expands its membership) or (2) the legal tender of any country which, as of the date of
such change, is a member of the Organization for Economic Cooperation and
Development and has a local currency long-term debt rating of either AAA or higher
assigned to it by Standard & Poor’s, a division of The McGraw-Hill Companies, Inc. or
any successor to the rating business thereof, Aaa or higher assigned to it by Moody’s
Investors Service, Inc. or any successor to the rating business thereof or AAA or higher
assigned to it by Fitch Ratings or any successor to the rating business thereof.

(b) Notwithstanding the provisions of Section 4.7(a), none of the following shall constitute a
Restructuring:

(i) the payment in euros of interest or principal in relation to an Obligation
denominated in a currency of a Member State of the European Union that adopts or has adopted
the single currency in accordance with the Treaty establishing the European Community, as
amended by the Treaty on European Union;

(ii) the occurrence of, agreement to or announcement of any of the events described
in Section 4.7(a)(i) to (v) due to an administrative adjustment, accounting adjustment or tax
adjustment or other technical adjustment occurring in the ordinary course of business; and

(iii) the occurrence of, agreement to or announcement of any of the events described
in Section 4.7(a)(i) to (v) in circumstances where such event does not directly or indirectly result
from a deterioration in the creditworthiness or financial condition of the Reference Entity.

(c) For purposes of Sections 4.7(a), 4.7(b) and 4.9, the term Obligation shall be deemed to
include Underlying Obligations for which the Reference Entity is acting as provider of a Qualifying
Affiliate Guarantee or, if All Guarantees is specified as applicable in the related Confirmation, as provider
of any Qualifying Guarantee. In the case of a Qualifying Guarantee and an Underlying Obligation,
references to the Reference Entity in Section 4.7(a) shall be deemed to refer to the Underlying Obligor
and the reference to the Reference Entity in Section 4.7(b) shall continue to refer to the Reference Entity.