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Greece, the CDS Market, and BNP

Felix Salmon:

The Greece basis trade: What could go wrong?: Why did Gretchen Morgenson write that column on Sunday about Greek credit default swaps? The answer is that the irresistible lure of writing about CDS lured her into the very murky waters of the Greek basis trade — the trade where you own Greek bonds and then hedge them by buying credit protection on Greece…. [T]he outcome of the trade is likely to set an important precedent for the sovereign CDS market more generally, so it’s worth looking in a bit of detail at exactly what’s going on here.

Basis trades belong to a set which is relatively common in financial markets: things which are meant to be very safe but which, in fact, aren’t…. [Y]ou buy a bond, which either pays off in full or doesn’t. If it does, you’re golden. If it doesn’t, then any losses you make on the bond can be recouped by profits on the CDS. So long as you buy the bond at a higher spread than the cost of credit protection, you should be guaranteed a modest profit. But the question is how do you get there from here. Because CDS are derivatives, they’re subject to margin calls, and if you can’t meet CDS margin calls, you might be forced to unwind your trade before maturity. And that can be very expensive…. So while the US government can play the basis trade without worries, everybody else has to treat it with a certain amount of caution. And all of that was true before various EU member governments started deciding, in a killing-the-messsenger kind of way, that there was something profoundly evil about the sovereign CDS market and that they wanted to start trying to ban it….

[I]f the EU wants to throw a wrench of some kind into the spokes of the CDS market, what could it do in Greece? One thing would be to simply encourage Greece to do a “voluntary” bond exchange which doesn’t trigger the CDS…. The thing to remember here is that if the CDS isn’t triggered in the bond exchange, it doesn’t just disappear in a puff of uselessness. It still exists, and it still protects bondholders from a payment default. If you hold the old bonds — if you haven’t tendered into the exchange — then in many ways your basis trade hasn’t changed. Either Greece continues to make the coupon payments on the old bonds, or else it doesn’t, at which point the CDS really should trigger and make you whole.

But there are two ways that the sovereign CDS market really could be damaged in the aftermath of an exchange. The first is if the untendered old bonds got impaired significantly while the CDS remained untriggered…. Greece, using its own domestic law as the instrument, changed the payment terms on the old bonds so that they were paying out only a fraction of what they were paying before the exchange. That would almost certainly be a credit event under the ISDA definitions, and would trigger the CDS. But… Greece and/or the EU might attempt to impair the old bonds and pressure ISDA to declare that the impairment doesn’t count as an event of default. I very much doubt that ISDA would ever make such a determination. But if it did, then that would be a serious blow to the sovereign CDS market….

CDS is a young market, which hasn’t been tested in lots of different circumstances. No one can know for sure how it’s going to play out in future. So far, the CDS market has held up pretty well…. And when CDS were triggered on Fannie and Freddie despite the fact that there was never any payment default, the market coped with that well, too. My guess is that CDS will do what they’re meant to do, in Greece. But BNP is trying to spread a certain amount of fear, uncertainty and doubt over whether that’s necessarily the case…