The European Union’s agreement with banks for a voluntary 50 percent writedown on their Greek bond holdings means $3.7 billion of debt-insurance contracts won’t be triggered, according to the International Swaps & Derivatives Association.
ISDA will decide if the credit-default swaps should pay out depending on whether it judges losses to be voluntary or compulsory. European leaders said in today’s agreement they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange” into new debt.
A last minute agreement was reached after banks, the biggest private holders of Greece’s government bonds, were threatened with a costly full default, according to Luxembourg Prime Minister Jean-Claude Juncker. The involvement of the Institute of International Finance, which represents lenders, also helped progress toward an accord that the EU could portray as non-mandatory.
“As long as the agreement is voluntary, then CDS aren’t triggered,” said Cagdas Aksu, an analyst at Barclays Capital in London. “Provided it’s voluntary, CDS wouldn’t be triggered unless the Greeks missed a payment.”
David Geen, ISDA’s general counsel in London, confirmed on Bloomberg TV’s “InsideTrack” with Erik Schatzker today that the agreement probably won’t trigger the swaps because it’s voluntary, even if there may have been some “coercion.”
The agreement “is borderline” though “from our point of view it is voluntary,” Geen said. “There’s been a lot of arm twisting.”
Leaders in Brussels agreed to boost Europe’s rescue fund to 1 trillion euros ($1.4 trillion), to recapitalize the region’s banks and get a commitment from Italy to do more to reduce its debt. The talks were regarded by many investors as a last-ditch attempt to stem the sovereign crisis and prevent contagion to Spain and Portugal, as well as Italy.
German Finance Minister Wolfgang Schaeuble is among European politicians who have expressed concern that credit-default swaps may have worsened the euro region’s troubles. Speculators can use the contracts to benefit as a nation’s creditworthiness declines because the price of the insurance they offer rises as the chances of default mount.
Still, a failure to compensate bondholders for writedowns may undermine confidence in credit-default swaps as a hedge and force banks to look at other ways of laying off risk.
“If they find a way to avoid a trigger event in the CDS, then people will doubt the value of credit-default swaps in general, leading to more dislocations in the market,” said Pilar Gomez-Bravo, the senior adviser at Negentropy Capital in London, which oversees about 200 million euros ($277 million).
Greek bonds soared and the euro strengthened after the agreement. The yield on the 10-year note dropped to 24.18 percent as of 12:27 p.m. in London, from 25.32 percent yesterday and compared with 12.5 percent at the end of last year. The 17-nation common currency gained to a 1 1/2-month high of $1.4018 from $1.3906 the day before, adding to its 4.7 percent advance this year.
The cost of insuring Greek debt fell. Credit-default swaps backing $10 million of the nation’s bonds for five years cost $5.6 million in advance and $100,000 annually, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately negotiated market. That implies an 85 percent chance of default assuming investors recover 32 percent of their holdings. The probability is down from 90 percent yesterday, when the upfront cost was $6 million.
“Obviously the plan is for the haircut on Greek debt not to trigger Greek CDS contracts,” said Marchel Alexandrovich, an economist at Jefferies International Ltd. in London.
The Markit iTraxx SovX Western Europe Index of swaps on 15 governments declined 32 basis points to 302 basis points, the lowest since Sept. 1. That’s still almost 100 basis points higher than at the end of last year. The Markit iTraxx Financial Index linked to the senior debt of 25 European banks and insurers plunged 28.5 basis points to 213, JPMorgan Chase & Co. prices show.
Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.
The net notional value of default swaps outstanding on Greece has fallen from $5.3 billion at the start of the year, according to the Depositary Trust & Clearing Co., which maintains a warehouse of trading data. The total is a fraction of the $390 billion Greek bond market.
“They need to draw a line under the whole saga and move on,” said Harpreet Parhar, a strategist at Credit Agricole SA in London. “Apart from the Greek banks, the rest should be able to take the hit and it’s in their self-interest to do so.”