The yield on 10-year Italian bonds is back over 6% following a weaker than expected bond auction. Who wants to load up on Spanish, Portuguese, or Italian bonds if they cannot hedge with credit default swaps?

No ISDA Ruling Yet

Everyone is acting as if the International Swaps and Derivatives Association (ISDA) has issued a ruling on on whether 50% haircuts forced at gunpoint are “voluntary”, but there is no official ruling yet, only hints.

Please consider Voluntary or forced? The important word games of debt default

When is a default not a default?

Investors struggled with that question Thursday after European officials outlined plans that would see owners of Greek bonds take a 50 per cent loss on the face value of their holdings.

The International Swaps and Derivatives Association, an industry group that oversees the CDS market, says the Greek deal probably won’t trigger default clauses in CDS contracts because the 50 per cent “haircut” is voluntary.

That view is starting to roil the $25-trillion market for credit default swaps because it calls into question the fundamental reason for purchasing insurance against losses on bonds. If investors can no longer count on being able to hedge against the possibility of a loss, they may start demanding higher yields as compensation for increased risk.

“I would think [such a ruling by the ISDA] would be quite a negative for the market,” said Lawrence Chin, director of research at the Cundill division of Mackenzie Financial. “You could get hit on the debt, but you don’t get the insurance [payout].”

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

But things can be confusing, even at the ISDA. In a version of the Q&A; dated July 8, the ISDA asks, “Does it matter whether the event is ‘voluntary’ or ‘mandatory’ ”? Answer: “The CDS Definitions do not refer to a distinction between voluntary and mandatory events, though it does come up indirectly.”

Then there’s the matter of just how voluntary the latest agreement really is. Banks may have agreed to take a 50 per cent loss on their Greek debt holdings to avoid an even worse deal.

David Geen, general counsel for the ISDA, acknowledged in an interview on Bloomberg Television that there was likely some “coercion” of banks by European officials. “There’s been a lot of arm twisting,” he said, but asserted that while the deal may have been “borderline.” it still fell short of being a default.

The Determinations Committee of the ISDA will make a final decision on whether the Greek deal triggers CDS payouts “when the proposal is formally signed, and if a market participant requests a ruling from the DC,” the association said in its Q&A.;

“If you can’t hedge your position, you shrink your position,” said Steven Tananbaum, managing partner and chief investment officer at GoldenTree Asset Management.

Fitch says 50% Haircuts would Constitute Default

Just to muddy the waters further, Fitch says acceptance of 50% haircuts on Greek debt would constitute default. Bloomberg reports …

If it’s accepted, “the 50 percent nominal haircut on the proposed bond exchange would be viewed by the agency as a default event under its Distressed Debt Exchange criteria,” Fitch said in a statement today. The accord is “ a necessary step to put the Greek sovereign’s public finances on a more sustainable footing.”

This week’s rise in the euro “shows expectations were very low for what would come out of the meeting,” said Geoff Kendrick, head of European currency strategy at Nomura Holdings Inc. in London. “I am relatively skeptical about how long this will last because I think it was just another plan for a plan.” Kendrick expects the euro to weaken to $1.30 by year-end.

Italian Prime Minister Silvio Berlusconi conducted the first test of investor enthusiasm for Europe’s debt since the summit’s plan was announced, selling bonds today at euro-era record borrowing costs.
Italian Sale

The Treasury in Rome sold 7.93 billion euros, less than the maximum 8.5 billion-euro target, of four different bonds today. The yield on Italy’s benchmark 10-year bond rose 11 basis points, or 0.11 percentage point, to 5.98 percent.

Fitch vs. ISDA

We come to the very real possibility that Fitch rules one way and the ISDA another.

Voluntary “No Default” Decision Could Kill CDS Market

The Wall Street Journal reports Default Insurance Market Takes Hit

Under the broad deal reached this week to stem the euro-zone’s financial crisis, holders of credit-default swaps on Greek government bonds aren’t expected to receive any payout, even though a preliminary agreement between financial institutions and European policy makers would recognize just half the face value of some Greek debt.

The decision not to trigger the swaps raises questions about the value of the insurance-like contracts and exposes the limitations of the hedging strategies that banks and investors have come to rely on. The swaps are widely used by bondholders and major banks to defuse a wide range of risks, and by traders to bet on market trends. If the swaps don’t pay out when bonds default, banks and funds that bought the insurance may face losses they thought they had hedged.

“You need the real money guys, the banks, to view [credit-default swaps] as a viable contract for CDS to be a real market,” said Adam Fisher, chief investment officer at hedge fund Commonwealth Opportunity Master Fund Ltd., and a trader of sovereign credit-default swaps. The deal reached Thursday, he said, could “kill off the market.”

“If you owned a sovereign bond and you got scared because you bought CDS thinking it would pay out, you’ll realize you would have been better off just selling your bond—and you’ll just get rid of everything,” said Ashish Shah, co-head of credit at AllianceBernstein.

The biggest U.S. lenders don’t stand to lose much on the Greek “haircut.” A bigger issue is exposure to economies such as Portugal and Ireland, and much bigger countries such as Spain, Italy and even triple-A-rated France.

I Predict a Surprise Default Ruling by ISDA

The WSJ implies a “decision not to trigger the swaps” has been made. Piecing together various reports, I don’t think it has.

Here is the setup. There is only $3.7 billion in CDS contracts on Greek bonds vs. €350 billion ($496 billion) government debt.

Will the ISDA be willing to risk the CDS market on sovereign debt for a lousy $3.7 billion? I believe it won’t if the “Derivatives King” (JP Morgan) and a few of the other big boys decide it is in their best interest to take a small hit now to prevent killing a lucrative market.

Thus I am going to go out on a limb and predict the ruling will be a default, possibly triggering massive buying of CDS contracts on Portuguese, Spanish, and Italian debt to the huge benefit of the “Derivatives King” and other big players.

Just don’t expect the same result next time if the big boys go on an insurance selling spree.

Mike “Mish” Shedlock
Click Here To Scroll Thru My Recent Post List