Foreign Emerging

Are Credit Derivatives Dead Because Greece Can't (Won't) Default

February 6th, 2012 | By Nick Sargen

My derivatives and foreign debt portfolio managers have been debating the status of Greek CDS (credit default swaps). Given that Greek sovereign debt is effectively in default but the CDS market has not officially acted in accord, what does this mean for the sovereign CDS market to properly function? What is the status of Greece CDS?

Howard Lodge, Derivatives Specialist, and Rance Duke, Credit Portfolio Manager, provide some insights in this interesting write-up.


Mark Twain supposedly said “Reports of my death are greatly exaggerated.” Greece seems in default by most observers today (as of 02/6/12). Yet, the ISDA (International Swaps and Derivatives Association) Credit Derivatives Committee has not declared default through the credit derivatives market. Since the market was created to allow people to buy and sell default insurance, does this mean people will no longer trade in the market?

We believe the short answer is the market will survive. It has experienced other issues before and simply rewrote the rules and made the market better. To understand this is to understand the history and evolution of the credit default market.

How and why credit derivatives originated

The original lending model was to make a loan, fund it by bank CDs (or however the institution obtained money) and keep the loan on the books. One earned the spread between the loan (asset) and the institutions cost of money (their liability). The institution was subject to default risk on the asset side and other risks such as matching asset and liability maturities, etc.

In the 80’s, the structuring market took off initially in residential mortgages. This allowed the lending institution to get the loan “off their books”. No longer was the originator stuck with the loans they originated. They could bundle the loans together, direct the cash flows (mainly principal and interest) to “tranches” and have people buy the tranches. They were then free to lend and earn the lending fees again since they got the initial principal money back from the tranche investors. Also, the loans existed in a pool that was structured as a bankruptcy remote trust. The thought was a lending institution bankruptcy was remote from the trust.

The top tranche in a deal typically was paid off first in principal, then the next, etc. All tranches got interest. Defaults reduced principal in the pool and the bottom most tranche.

But, what protected the end investor in the tranches from unanticipated default? The end investor wasn’t there when the loan was originated. They weren’t at the deal table when the deal was struck.

The answer was the rating agencies. A tranche with AAA rating (a “high tranche”) was supposed to rarely, if ever, default. But, who paid the rating agencies? The answer is the very people who originated the loans (say, a bank) and structured the pool and tranches (the investment bankers). It was as if one of the lawyers in a trial paid the judges salary.

In the 90’s credit derivatives entered the scene. They were also a means of getting loans off the books. Once again, we start with the banks making a loan. Instead of securitization, the banks bought protection. Others sold it. If the company defaulted, those who bought protection would get paid par (say $1,000,000) from the seller. In exchange, the buyer of protection would give the seller a bond on the company and the seller would get recovery by selling the bond. Thus, the buyer was “insured” and the seller was out par - recovery.

Someone who bought a bond and paid par would be out the same as the seller of protection. Both would be out par minus recovery. Thus, the seller accepted the risk of default and the buyer insured themselves. Once again, the loan was off the books. But, was it?

The sticky issue is the definition of default. The bonds of US corporations define default as (1) bankruptcy and (2) failure to pay. A credit default swap adds (3) restructuring. This was because loans could be restructured (payment terms changed), the bank could lose value (present value of worth) and the regulators wanted any loss in value to be eliminated when one bought protection. They wanted the loans “off the books” and unless restructuring was included in the definition of default, the loans weren’t off the books.

This requirement has caused much pain. Constant modification of the wording (for example, modified restructuring, etc) led to many exciting moments in legal courts!


The new credit derivative – Sovereign Credit Default Swaps

Enter Sovereign default swaps (on countries), Greece and 2011. Default has not been called as of 11/7/11 on Greece. Why?

According to Citi's economists, a reduction in the share of fixed investment in GDP by 10% is overdue, and the question is whether this reduction can be achieved without overall demand weakening. In Citi's view, monetary and credit policy have limited power, because the corporate sector is highly levered and the banking and shadow banking system have extremely weak balance sheets. Also, while Citi's economists anticipate future cuts in interest rates and in the required reserve ratio, they contend benchmark lending and deposit rates have little impact on interest rates set in the markets:

One word - and it isn’t plastics – is “entanglement.” Observed first, perhaps, with Long Term Capital in 1998, derivatives that require settlement and collateral that has not been posted can lead to credit issues at multiple institutions. A calls B for money because of a derivative position, B calls C, etc. Recently (2008) we had Lehman and others. There must be pressure to not call default today for fear of entanglement of European and American financial institutions.

The entity that is responsible for calling derivative default is the European Committee of ISDA (International Swaps and Derivatives Association, Inc). Their view is that private transactions are voluntarily occurring and that doesn’t constitute default. If we trade you $1,000,000 Euro bond backed by Greece for $500,000 Euro bond backed by France, we don’t have default (under the restructuring clause). It was a voluntary tender, not a default under restructuring. Since it traded, both sides set fair value at the exchanged level. An official exchange rate (“haircut”) has been declared for Greece (50%) but that still has not triggered default


What should we do?

We believe we should have two contracts – one for markets that have no bankruptcy courts or clear definition of default and another contract for markets that do.


The Sovereign Markets

Since no definition of default exists, let sovereign credit derivatives be simply reflections of credit worthiness of countries. Forget default. Spreads widen and narrow without actual default. After all, US corporate bonds have traded for many years with minimal actual default.

Even if there was a definition, no mechanism exists for settling claims. There are no sovereign default judges or courts. Even if there were courts, they would have to have jurisdiction over the different countries.


Markets Referencing Legal Entities with Bankruptcy Courts

Where there is a mechanism for enforcement, delete restructuring. For example, credit derivatives on US corporations would have bankruptcy and failure to pay as the only definitions of default.

Banks would not have the loans off the books as far as marks go. They would if default. This seems to take us back to the original system. That is, the loans are on the books and spread widening and narrowing reflect risk. Credit default swaps only function in the “black swan” event of true default.

As stated in the beginning of this paper, this market is willing to learn and has often shown great flexibility in the past when problems arose. For example, cash settlement became the major mechanism for settlement when there were not enough bonds to deliver in the credit default market. This allowed for more credit derivative “notional” than physical bond par for a particular company. Thus, the credit derivative trading drove the cash market spreads.

Is that bad? We think not necessarily.

Think of the swap (Libor) market. That is many times the “cash” labor note market but has been well behaved. Having more derivatives than “physical” bonds is very common in the derivative market.

In summary, we suggest they clarify the default language in contracts and make it more like bond default language. This the main issue, not the fact that there are many times the number of credit derivatives than physical bonds in a particular corporate name. For sovereign credit derivatives, just let it reflect credit spreads.


[1] Citi Research, Global Economics View, "Is China Leading the World into Recession?" September 8, 2015.

[2] See Robert Z. Aliber, "One More Note on China", (preliminary) September 6, 2015.

[3] Ibid, p. 15.

[4] Aliber is a co-author with Charles Kindleberger of the classic Panics, Manias and Crashes, and he is currently writing a book on the causes of asset bubbles and financial instability.