27 october, 2011
As a result of labeling 50% haircuts "voluntary", Credit Default Swap contracts have proven to be useless when it comes to protecting against sovereign default. The serious implication is investors will need to find another way to hedge.
The European Union’s ability to write down 50 percent of banks’ Greek bond holdings without triggering $3.7 billion in debt-insurance contracts threatens to undermine confidence in credit-default swaps as a hedge and force up borrowing costs.
As part of today’s accord aimed at resolving the euro region’s sovereign debt crisis, politicians and central bankers said they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange” into new securities. If the International Swaps & Derivatives Association agrees the exchange isn’t compulsory, credit-default swaps tied to the nation’s debt shouldn’t pay out.
“It will raise some very serious question marks over the value of CDS contracts,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “For euro sovereigns in particular, the CDS market is likely to remain wary.”
This approach may undermine confidence in credit-default swaps as a hedge and force banks to look at other ways of laying off risk, according to Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros ($277 million).
“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” she said.
“It is symptomatic of the regulatory and legal goalposts being constantly shifted either randomly or to suit political interests,” said Marc Ostwald, a fixed-income strategist at Monument Securities Ltd. in London. “For genuine long-term investors, either financial or non-financial, it’s a major liability.”
CDS on Greece a Purposeful Sham
Janet Tavakoli writes “Standard” Credit Default Swaps on Greece Are a Sham and It’s Not a Surprise
“Customers” that accepted ISDA documentation when buying credit default protection on Greece are now discovering that ISDA defends the position that a 50% discount on Greek debt is “voluntary” and therefore not a credit event for credit default swap payment purposes according to its documents.
First Step in a CDS: Protect Yourself from the ISDA Cartel
As previous sovereign problems have illustrated, the only way to buy protection is to rewrite the flawed ISDA “standard” document and agree to new more sensible terms, before concluding the initial trade. One has to first protect oneself from the ISDA cartel “standard” documentation before one can buy sovereign default protection, or any other protection for that matter.
This isn’t the first time investors have been burned in the sovereign credit default swap market. Hedge funds Eternity Global Master Fund Ltd. and HBK Master Fund LP thought they purchased protection against an Argentina default and sued when J.P. Morgan refused to pay off on Argentina credit protection contracts they had purchased.
At issue was the definition of restructuring. Did Argentina's "voluntary debt exchange" in November of 2001 meet the definition of a restructuring? The Republic of Argentina gave bondholders the option to turn in their bonds in exchange for secured loans backed by certain Argentine federal tax revenues. J.P. Morgan claimed this didn't meet the definition of restructuring, at least for the protection it sold to Eternity.
J.P. Morgan's story was different when it wanted to collect on the protection it bought from Daehon, a South Korean Bank. J.P. Morgan claimed its slightly different contract language met the definition of restructuring under the credit default protection contract it had with the South Korean Bank.
In other words, J.P. Morgan made sure its contract language would allow it to get paid when it bought protection and would make it harder for its counterparty to get paid when it sold protection.
Language Arbitrage: You’re Not a Sucker, You’re a Customer
Banks that play this game call it “language arbitrage.” Anyone that bought sovereign credit protection on Greece after accepting ISDA “standard” documentation without modifying the language now finds that they are on the wrong side of an “arbitrage.” An arbitrage is a riskless money pump. In this case, it means that money has been pumped out of credit default protection buyers with no risk to their counterparties, the financial institutions that ostensibly sold them credit default protection on Greece.
Derivatives King Always Wins
Note how the "Derivatives King" JP Morgan wins on its contracts, even on both sides of essentially the same bet.
By the way, I have a couple of questions:
1. What the hell are banks doing in all these derivatives markets in the first place?
2. Isn't it time banks act like banks instead of arbitrage hedge funds?