Thought things couldn’t get more complicated for Greece? Think again. Investors in Credit Default Swaps (CDS) tied to the March 20th bond series will have grounds to seek remuneration if the current debt write-down goes through.
The reason is simple: CDS investors bet against Greece with the expectation that they would receive a return if the nation failed to repay its bondholders by the March deadline. The problem is, Greek officials are trying to strike a deal with bondholders that would move the deadline and keep the country from defaulting on grounds of a technicality. Such a measure would effectively cheat CDS holders of any return to which they were entitled after correctly predicting that Greece would be too insolvent to repay the bonds on time.
Einhorn’s FOF Re-positions Portfolio, Makes New Seed Investment In Year Marked By “Speculative Exuberance”
It has not just been rough year for David Einhorn's own fund. Einhorn's Greenlight Masters fund of hedge funds was down 3% net for the first half of 2020, matching the S&P 500's return for those six months. In his August letter to investors, which was reviewed by ValueWalk, the Greenlight Masters team noted that Read More
First Things first: The Proposed Deal
After confessing that it cannot repay the full amount owed to bondholders, Greece is asking each investor to “write down” bond face value receivables by 50%. This write-down would allow investors to report a portion of the default as a book loss, which may be most tax-advantageous to investors at this point, and which would lower Greece’s own book liability, improving the position it can show to new creditors. Also part of the deal are requests to allow the new coupon rate to fall to 4%, and to delay the payback date to several years into the future.
If Greece gets what it wants, the bonds will never fall into default because the bond contract will have been revised to show a new due date before default could have “technically” occurred. The informal deadline for striking a deal to avoid technical default was January 30th on the grounds that it would require some 7 weeks of administrative assembly to execute a deal and have new measures in place by March 20th.
Could This Really Be Legal?
The legality of denying CDS investors in this situation is unclear, though logic dictates that individual contract wording and the forensic definition of a “default” would come into play if underwriting institutions chose to fight it. Precedent would also play a role: if a single underwriter considered a bondholder deal to be a CDS trigger, other underwriters would face pressure to do the same.
Yet, many of the underwriters themselves are in serious trouble. While some bondholders bought CDSs as a hedge against their own bond purchase, other bondholders sold CDS hedges. Those institutions may have to pay out on hedges while also taking a loss on the principal investment related to the original bonds. For yet others, there are institutional fears of solvency vis a vis the payout of these hedges. If the underwriters can’t afford to pay out on the CDSs, a new set of protective measures could emerge. Specifically, collateral requirements on contracts related to other countries could skyrocket, freezing up even more capital needed by already-stretched banks.
Another Implication: The Rating Agencies
Restructuring the deal to avoid a technical default will also have a complex impact on the country’s credit ratings. While rating agencies Moody’s, S&P, and Fitch would certainly take action if a technical default occurred, it is unclear how they will treat this “near miss” that is being deliberately engineered to avoid a slew of ancillary consequences. Will these agencies revise ratings to reflect Greece’s inability to honor its March 20th commitment? If so, when, and will it be punished to the same degree as in a technical default? Moreover, if the rating agencies consider a last-minute restructuring tantamount to a default, will this set a precedent that helps CDS investor claims?
Last week’s Bloomberg Television interview with a spokesperson from S&P saw the rep using default terminology. “Greece will default very shortly,” said the S&P official. In the same week, a Fitch official told Reuters, “It is going to happen. Greece is insolvent so it will default. So in that sense it shouldn’t be a surprise to anyone.”
Up Next: CDS Underwriters to Spiral Into Disorderly Default?
Most mention of “disorderly default” these days is in reference to Greece, yet the nation’s own default will bring backbone institutions down with it. A CDS payout, while making some investors whole, would be yet another blow to the world financial system. It would force some of the largest and most influential global banking entities under greater scrutiny, therein raising costs (which will, as always, trickle down to consumers).
Yet, a disorderly default is all but guaranteed at this point, given the length and lack of success in Greece’s recovery efforts. Add in the complexity of its relationship with Europe and the relative youth of a political union unaccustomed to cross-border collaboration and tough economic problem-solving, and the truth becomes clear: a complex bond write down may solve one small interim problem while felling the first domino that will set off many others.