Will Greece default or won’t they? Repo traders want to know…..

The back and forth about Greece’s debt restructuring has obvious knock-on effects to the CDS market. But it also impact the repo market too. A voluntary restructuring means, in ISDA’s view, that the CDS contracts don’t trigger. However it is looking increasing likely that the deal can’t be done on a purely voluntary basis. Is that surprising? It shouldn’t be..

If the Greek government did the swap and then decided not to pay any stray debt holders who didn’t participate in the exchange, a default would kick in. In a February 21, 2012 New York Times article, Steve Kennedy from ISDA was quoted, “If one investor had $1.1 million of debt and decided not to tender in an exchange, and the debt issuer stopped making payments on that debt, it would trigger a credit event…”

Imagine a world where there are no credit default swaps and investors have a choice of taking the exchange terms behind door number one or, well, a long court battle to press their claim. It kind of sounds like the Argentine default. There is incentive to accept the deal, although there will always be some random player who will take their chances, trying to attach a government owned airplane or something like that. But the game changes when the alternative is a 50% plus haircut behind door number one or par from a triggered CDS behind door number two. Owners of CDS protection are actually rooting for default. It is an interesting application of game theory.

One way for Greece to push holders toward accepting a new deal is to, somewhat after the fact, include collective action clauses (CAC) in the bonds. Greek bonds typically don’t have them already. This would mean as long as a prescribed percentage of bondholders vote to take the restructured deal, that all investors would be forced take it. ISDA has said triggering a CAC is tantamount to a non-voluntary restructuring since those who voted against it are still subject to it. That kind of stuff triggers CDS credit events and, voila, CDS protection holders get par.

The volume of CDS on Greek debt is modest ($3.2 bio net at the last count) and the trades are margined. The exposure is largely covered already. So, thankfully, we are not talking about systemic apocalypse. The EC is worried about the dominoes falling – first Vietnam Greece, then Laos Portugal, then Cambodia Spain and Thailand Italy. What could create that kind of contagion? We wonder how many first to default baskets are out there which contain Greece as a reference entity? It wasn’t so long ago that investors in a first to default basket would not think too hard about adding any or all of the PIIGS if it could earn them a couple more basis points. Those baskets will unwind in the case of a Greek default and act as a transmission mechanism for market stress. Is that exposure counted anywhere?

Why do repo traders care? The CDS market stole the repo trader’s lunch. Synthetically embedded in a CDS is a long term financing trade. If the CDS market becomes dysfunctional, the alternative way to buy protection will be a short cash position plus a repo. There already are some signs of this happening. Finadium wrote about this in the February report “The Credit Default vs. Repo Trade”. A link to the synopsis is here.

A link to the referenced New York Times article is here.

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