The Greek Debt Timeline and Control Rights

The details of the write-down of Greek debt are set, or at least set conditionally, it will be very interesting to watch how the markets respond.  On the details, this figure sets out the timeline and how market/debt-holder participation influences the process.

After all this time and European money, a flat out default is still quite possible.   And it is also interesting to note that the structure has not solved the free-rider problem or the CDS problem.  Some debt holders may not accept the terms of the restructuring in the hope that others will be restructured and they will be paid in full.  This problem may bring the whole structure crashing down.  Some investors may have debt which is written down by more than appropriate for its term (e.g. long-term debt holders taking very severe write-downs or short term debt holders taking even modest write-downs).  The CDS problem is that insurance creates moral hazard.  The decision-maker for any given debt instrument may not have an interest in maximizing the payoff of the debt and may instead prefer full default or a differently structured write-down (or even be over-insured and benefit from a complete default).

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Greece defaults without defaulting

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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On Sovereign Default by European States

Here is an excellent piece on the likely Greek default by Marty Feldstein. A great topic in the hands of a great economist who writes clearly.

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The Dealers vs. Financial Reform

Robert Litan has written a forceful, balanced, and brave discussion of financial reform. Here is an excerpt:

I have written this essay primarily to call attention to the main impediments to meaningful reform: the private actors who now control the trading of derivatives and all key elements of the infrastructure of derivatives trading, the major dealer banks. The importance of this “Derivatives Dealers’ Club” cannot be overstated. All end-users who want derivatives products, CDS in particular, must transact with dealer banks …

I will argue that the major dealer banks have strong financial incentives and the ability to delay or impede changes from the status quo — even if the legislative reforms that are now being widely discussed are adopted — that would make the CDS and eventually other derivatives markets safer and more transparent for all concerned.

If you care about the prospects for meaningful financial reform, you should read Litan’s essay.

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Credit Default Swap Update

In a blog entry almost six months ago, I suggested that prices for credit default swaps (CDS) would tell us when the financial crisis was winding down. Unfortunately, the data this week tell us that the end is not in sight. This is probably obvious to you given the news headlines of the last few days, but looking at credit default swaps can help us understand how bad things are.

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When Will We Know?

Reporter: But now I’m asking you: When will we know?
Henry Hurt: Blackout lasts for 3 minutes. If they’re not back in 4, we’ll know.
—Apollo 13

When will we know that the credit crisis is over? One way to tell will be by looking at the market for credit derivatives. Credit default swaps (CDSs) permit investors to buy or sell insurance against the event that a specific company defaults (or more generally, experiences a “credit event”). The buyer of insurance pays a quarterly or semiannual premiums to the seller. In return, the seller promises in the event of default to pay the buyer the loss in bond value due to default. When CDS premiums are high, it is a sign that investors are worried about a default.

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