Credit Event Or No Credit Event, This Will Get Messy

We have noted again and again that the seemingly single-minded effort to avoid a credit-event or involuntary restructuring is yet another one of the actions of an ignorant and ill-informed elite who simply do not understand the unintended consequences of any and everything they do to calm a desperate banking system. Today saw Willem Buiter, of Citigroup, agree with our perspective in terms of both the realistic lack of impact from a CDS event on Greece (per se) and moreover his perspective that the lack of a credit event could throw bond markets into a chaotic state as seemingly worthless CDS contracts and CTD bonds are tossed like hot potatoes from one smart banker to another smart hedge fund.

The Greek 5Y CDS-Cash basis until last week - expect volatility to explode in this relatively calm position.


He notes:

Not triggering CDS in a deep Greek sovereign debt restructuring would likely be more damaging than triggering


In that case, the value of CDS as an asset class – which retains a significant hedging and risk management role – would be much impaired

The lengthy Citigroup prose is summarized rather simply as avoiding the trigger when it is obviously a trigger-worthy event (using our vernacular) could cause far more trouble than any they are seeking to avoid for fear of contagion and losses. Peter Tchir, of TF Market Advisors,  added this evening:

Given the number of European Leaders who are still up and making statements, it would seem we finally have a deal.  Either that or they were all clubbing together, which can't be completely ruled out.


50% haircut for banks.  Will the banks actually be forgiving Greece 50% of their obligations or are the banks about to get some super cool security that has lots of bells and whistles, so they can say it is a 50% write-down?  I'm betting the latter, which just means EFSF funds get used up more quickly.


This will NOT be a Credit Event.  As I sent earlier, it doesn't fit the legal definition of Credit Event in the ISDA documentation.  I would expect the "basis" to go out of control, as banks sell useless CDS hedges.  I am not sure what the immediate impact on the broader sovereign bond market will be.  It may try to react positively to the "deal" and the CDS tightening, but I would be careful as sophisticated banks will be busy selling their bonds now too.  The "dumb" banks will probably try and sell as much sovereign CDS as they can and cut bond exposures in other countries, because this is now the best risk-free asset on the planet :)  The CDS does remain outstanding, so it doesn't go away if it doesn't trigger.


It will be interesting to see who participates in the "haircut"   Will all the banks really participate?  Will the ECB's bonds be included?  Will bonds held by Greek pension plans?  What about bonds held by hedge funds?  I would assume anyone who manages to keep some old bonds should see an increase in value (if the haircuts are real, and not just a symbolic calculation).  Who gets forced into participating will create precedents that may have some serious impact on the market.


The new capital injection calculation of just over 100 billion EUR seems low.


The idea of austerity in Portugal will likely be thrown out the window.  Going to be hard to suck up and swallow austerity when your buddy down the road just got some debt taken off the books.


Italy will have to play nice so it can get some of the leveraged EFSF money - which is as likely to just cannibalize the straight debt as anything else.


The rating agencies will finally have some real numbers to play with as it seems details have to be getting close.  I don't think their reactions will be particularly positive - as it does nothing to fix problems at the weak countries, and drags France and Germany into the morass.


It should be an interesting morning, and about the only thing I am truly certain of, is I would not want to be long the basis package if I worked at one of the institutions that agreed to the IIF deal (assuming it is a real deal and actually has real haircuts).  I would love to see the look on the faces of some EU ministers when they realize that hedge funds are probably the largest beneficiary of their blatant manipulation of the Greek CDS market.


If they ever get around to creating the EFSF, I would read the fine print very very very closely.