An interesting aspect of the European rescue plan for Greece is that the ISDA (the International Swaps and Derivatives Association) ruled that the restructuring was not a credit event for the purpose of settling credit default swaps. ISDA’s rationale is that the restructuring was voluntary — if you want to continue to hold unrestructured Greek debt, you can. Nevertheless, many bondholders will have a financial experience equivalent to a default; they will take a writedown on their debt, accept lower coupons, and have a guaranteed principal payment.
Probably a goal of the rescue was to avoid creating a credit event. There were fears that an official Greek default would cause CDS sellers to fail (remember AIG?), in which case CDS buyers (such as banks) who thought they had hedged their Greek government bond positions would not have been hedged, and this could have caused a cascade of failures. It’s hard to know if this was a plausible scenario, but this time at any rate, we won’t have to find out.
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Won’t this ‘default without a default’ particularly hurt the CDS buyers who had a reason to hedge but, because of the ISDA’s funnybusiness, are left high and dry? The buyers get hit in both scenarios: 1) the ISDA calls it a default but the CDS sellers can’t pay, and 2) The ISDA doesn’t call it a default so CDS buyers don’t get paid anyways.
So the potential cascade would have to come from somewhere else. Perhaps the CDS sellers are in a particularly weak position or they sold an inordinate amount of insurance. The ISDA apparently wants to prop up the CDS sellers but is okay throwing buyers under the bus.
Good question. Keep in mind that CDS prices track bonds prices, so that when the CDS premium falls the non-restructured bond price should increase. It appears that both did happen, though i didn’t try to compute the return on a hedged position. A harder question to answer is how the CDS price relates to the price of a restructured bond. I’m not sure.