October 28, 2011 / 8:16 AM / 8 years ago

Dealers reassess value of sovereign CDS after Greece plan

* Sovereign CDS undermined when regulatory pressure can be applied

* Talk of death of the market over-done, traders say

By Christopher Whittall

LONDON, Oct 27 (IFR) - Plans to avoid triggering Greek credit default swaps when restructuring Greek debt have raised questions over the value of banks using sovereign CDS to hedge exposures to jurisdictions in which regulators are able to exert considerable pressure on them.

Policymakers presented plans for a voluntary debt exchange of Greek bonds with a 50 per cent haircut early Thursday - a move which should not trigger CDS, lawyers say, as it would not bind all bond-holders. Dealers say the latest plans have confirmed previous fears that regulators would undermine sovereign CDS as a hedging tool by deliberately looking to avoid a credit event.

“People talk about Greek CDS triggering being destabilizing, when it’s really the opposite,” said one global credit trading head at a major European bank. “If there is a 50% haircut and it’s voluntary, then my worry is all my sovereign CDS protection in Europe is useless, and my net exposure [to European sovereigns] is much higher. The next level will be calculating how much actual exposure people have, and how much is hedged out by CDS - the exposures could be much bigger.”

One senior trader agreed it raised questions over the value of sovereign CDS, but argued it depends on the country the bank in question is looking to hedge against. For example, a European bank can be strong-armed behind the scenes by its regulator into accepting a 50% haircut on its Greek bonds, which wouldn’t trigger CDS and therefore arguably make its hedge worthless.

However, a non-European bank - or other bondholders such as hedge funds, asset managers or even retail investors - shouldn’t have the same regulatory pressure to participate in a voluntary debt exchange. If they opt not to participate, the principal on their bond would remain the same, and so their CDS hedge would still be valid.

“There is probably too much moral hazard for a bank using sovereign CDS as a hedge in a jurisdiction where their primary regulator can have an undue influence on them, and people should think long and hard about the benefit of that hedge,” said the European credit trading head at a US bank.

“But if it’s truly voluntary, then they can’t coerce people to do it outside the Eurozone where they have the policy influence on them. So some banks may lose by having their bonds haircut and their hedge made worthless, while conversely some might win by retaining the bond at par, and retaining [a working] hedge,” he added.

The ramifications may extend beyond people using CDS to hedge bond portfolios, however. Sovereign CDS are also used to hedge against corporates within that jurisdiction that are too small to have their own reference CDS. If sovereign CDS is thought to be ineffective, it could potentially inhibit a bank’s ability to take exposure to these foreign counterparties.

“This does extend beyond Greek CDS. We’re now unlikely to hedge Portugal risk with Portuguese CDS,” said one head of European credit trading at a major European bank.

“If I can’t hedge [with sovereign CDS] it’ll affect my corporate risk appetite,” added the global credit trading head.

However, sounding the death knell for sovereign CDS would be premature, dealers argue, even if it will be necessary to think harder about the real value hedges represent.

“The regulators have been very transparent that CDS would not get triggered,” said one European credit trading head at a European bank. “The reality is, even if banks don’t think it’ll trigger they would still prefer to have some CDS on because on a mark-to-market basis it can actually gain. It also lowers risk limits and helps get some RWA relief. This mark-to-market gain part of it is not going to change.”

Any CDS trigger - or lack thereof - should not be for a while. The debt exchange is scheduled to take place in early 2012, at which time the International Swaps and Derivatives Association Determinations Committee would rule on whether there had been a credit event. At present, ISDA has indicated the restructuring should not trigger CDS.

“Based on what we know it appears from preliminary news reports that the bond restructuring is voluntary and not binding on all bondholders. As such, it does not appear to be likely that the restructuring will trigger payments under existing CDS contracts,” ISDA wrote in a statement on its website.

Meanwhile, participants have already called into question the likelihood of pulling off such a large haircut of Greek debt on a voluntary basis. According to the European Banking Authority’s latest stress tests, European banks - which would be most susceptible to political pressure to accept the exchange - only hold EUR98.2bn of Greek debt compared to a total outstanding of around EUR350bn.

According to the Depository Trust & Clearing Corporation, total net exposure of market participants who have sold CDS credit protection on Greek sovereign debt is approximately US$3.7bn as of October 21, compared to US$6.3bn at the beginning of the year. Greek CDS rallied Thursday to around 55 points upfront from 60 Wednesday.

Analysts have pointed out past emerging market restructurings done a voluntary basis were done with less than 30% haircuts. As a result, the number of hold-outs on a 50% haircut could well be far higher, meaning the authorities may yet be forced into a mandatory debt exchange that would trigger CDS.

“They struggled to get a participation of 75% when the haircut was 21%. So now they think they’ll get a 75% participation at 50%? I know where my money is on that,” said the European trading head at a US bank.

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