Credit default swaps get tricky

Financial Review

PUBLISHED: 10 Mar 2012

Anna Bernasek, New York

This week’s Greek debt restructuring lifts the curtain ever so slightly on a private realm in finance. Normally the exclusive domain of big-name hedge fund managers and investment bankers, the inner workings of the multitrillion-dollar credit default swap market have come to light since Greece began negotiating with its bondholders.

A look at how credit default swaps are constructed and how the market actually works raises some interesting questions about the value of these instruments and who benefits from them.

Credit default swaps are often compared with insurance contracts on bond investments. It is estimated that the global CDS market covers about $US32 trillion of bonds. That’s the so-called “notional” amount payable if every CDS were triggered to the maximum possible extent, which would happen if all the underlying debt became worthless.

While credit default swaps were invented in the early 1990s, they gained popularity as a speculative investment about 10 years ago.

There is no detailed reporting on credit default swaps in the US. making the market almost totally opaque here. Outside a select circle of dealers no one knows who holds the contract or who is on the hook to pay, or whether indeed they have the money to pay if required.

The dealers, of course, love it this way. When dealers are the only ones with the details, margins tend to fatten.

Typically, investors buy a credit default swap from a dealer to cover a loan that might sour. In the case of Greece, investors bought credit default swaps in the event Greece defaulted, thereby undermining the value of its bonds.The idea of insurance on a bond is simple. If the bond defaults, the insurer pays. But in a situation such as Greece’s, the devil is in the detail. Literal default isn’t the only way bondholders can lose. It would be a gross failure of imagination for Greece to do something so straightforward as a simple default.

Payment of a credit default swap cannot be made unless there is a credit event ruling by the International Swaps and Derivatives Association (ISDA) that the event is a default or, under the circumstances, amounts to one.

ISDA itself is a consortium of big banks and investment firms. Their names read like a who’s who of Wall Street: Bank of America Merrill Lynch, Barclays Capital, BNP Paribas, Credit Suisse, Deutsche Bank, Goldman Sachs, JPMorgan Chase, Morgan Stanley, Société Générale, UBS, BlueMountain Capital, Citadel, D. E Shaw, Elliott Management Corporation and PIMCO.

That means whatever Greece does, it will be up to ISDA to decide whether the contract is triggered. So the same people who plump up the CDS market, and the only ones with any visibility on who owes what to whom, will decide whether the swaps will pay out or not. Their ruling is final. There is no option to appeal.

Outright sovereign default is not very common. The last major country to default on part of its debt was Argentina in 2002. So the Greek debt restructuring is really the first big test of the market since credit default swaps have grown in popularity.

What makes this case so intriguing is that it highlights some fairly obvious conflicts of interest, especially surrounding the judgment required to trigger a payout.

On March 1, as the recent Greek debt exchange offer approached, ISDA made an unusual and lawyerly ruling, saying that credit default swaps would not be triggered based on a particular set of circumstances, notwithstanding bondholder losses. That left investors on both sides of Greek credit default swaps with a lingering question: Will the CDS ultimately cover almost certain Greek loan losses?

It’s a bit like having insurance on your home during a flood. You may think you’re covered, but you won’t really know until you hear what the company has to say.

Even after the Greek exchange offer this week, holders of credit default swaps on Greek bonds couldn’t be sure if they would be paid out until ISDA says so. Greece received a majority of investors voluntarily accepting the debt swap and can force those holding out to accept the terms of the deal. As a result of that coercion, most expect ISDA to rule that Greek credit default swaps are triggered and force them to pay out.

Even if CDS in the Greek case are triggered, the process shows the vulnerabilities of a market where interested parties exercise much control. Generally if you have a dispute over a product, you can tell your story to an arbitrator. Not so with credit default swaps. Your dispute goes to a committee of dealers in the product. The identity of each person is a secret.

The Greek case shows that even for seemingly sophisticated players credit default swaps can still prove tricky. We’ll have to see whether these financial instruments stand the test of time.