Default, Credit Event, And Too Big to Fail

Posted by on Oct 28, 2011 in Uncategorized | No Comments

It looks like Fitch would declare a 50% write-down a default.  And yes, it is a default.  No matter how anyone wants to spin it – restructuring, PSI, etc., it is definitely a default.  It is NOT a Credit Event.  Maybe the name should be changed from Credit Default Swaps to Credit Event Swaps because that’s what they are.  They should be called CES’s rather than CDS’s.  And then if you did synthetic CDO’s, you could call them CESSPOOLS.

Anyways, it is bizarre, but no matter what the rating agencies do, it won’t affect whether or not a Credit Event will have occurred.  But it could have implications elsewhere.  If Greece has a lot of interest rate or currency swaps on, there may be collateral provisions that kick in, or automatic unwinds, if Greece “defaults”.  It is pretty standard to have cross default covenants in an ISDA master agreements/Credit Support Annex.  That language would differ from a CDS contract definition.  I’m not sure any dealer would have the guts to close out interest rate or FX swaps with Greece based on a cross default provision, but it adds another element.

There may be other bilateral contracts out there that do have implications if Greece is deemed to “default”.  I haven’t looked at their bonds closely, but there may be some ability to accelerate if Greece defaults?  The bonds I looked at didn’t have language that made it likely, but I will look to see if some do.

In theory, if a bond was “defaulted” a bank should mark it to market and run the loss through capital.  I suspect, that since banks will own new bonds that are current, the event of default will be “temporary” and the regulators are fully on board anyway, that they won’t be forced to take a mark.  We still haven’t seen what the IIF proposal actually, so it is hard to say how the restructuring will be accounted for.

Rating Agencies declaring it an event of Default may have implications elsewhere in the market, but it won’t affect whether or not it is a Credit Event for CDS contracts.

On a separate note, Dexia which was big in OTC derivatives, including CDS, needed to be bailed out.  MF Global, which is big player in listed, exchange traded derivatives, is being left to hang in the wind.  I have no particular opinion on MF Global, but I do think it highlights the need to get CDS on an exchange, where the risk and counterparties can be controlled and transparent.  I would guess that we are getting some strange moves in some commodities from MF unwinds, but I have not heard anything about systematic risk or fear that the exchanges will not be able to honor other customers – because MF has been posting fair collateral in exchange for their futures trading.  I think this is just another glaring example of how much better the system functions in exchanges.  Possibly less money for some banks in that scenario, but the overall good seems to outweigh that – or at least it should, since we have been spending the better part of the last 4 years trying to prop up the banks somewhere in the world.  It is strange that they were able to issue a bond on August 3rd.