Credit default swaps

Much has been written in the press in recent months on Greece and its contribution to the current debt crisis, including in this column. Market players concerned about a Greek default have been buying CDS, instruments which should protect them against any financial loss – but it is still unclear whether any eventual exchange could trigger a credit event.

Voluntary restructuring or exchange would probably not constitute a credit event- Vincent Micallef

A Credit Default Swap (CDS) is a financial derivative which gives the buyer protection against loss of capital should the underlying bond issuer default on its obligations, in the same way that an insurance policy protects other assets.

In technical terms, the buyer of credit protection is short credit risk, the seller being long this risk. The “protection seller” is the counterparty providing protection against default, i.e. the seller will compensate the protection buyer for loss incurred upon default.

The premium on CDS as quoted by financial news providers shows an annual spread.

It is paid in part by an upfront amount, and partly as a coupon paid on a quarterly basis. Should a default in the underlying bond trigger a credit event, the CDS pays the holder the difference between the bond’s par value and the amount recovered on the defaulted bond through auction.

The buyer need not hold the underlying bond to buy a CDS – in fact a holder might take the view that an issuer may pass through a difficult period, and hence is prone to default. In this case, the buyer will purchase a CDS and hold it till an eventual default, or simply sell it at a later period when the issuer’s situation worsens and hence the CDS premium increases.

There are a number of actions that qualify as credit events. These include bankruptcy, failure to pay coupon or principal payments when due, repudiation or a moratorium and restructuring of debt.

If Greece redenominated its obligations into a non-permitted currency (e.g. the drachma) this would constitute a restructuring credit event.

There is growing concern that Greece could try to restructure its debt in a way that avoids the negative press of a default or formal restructuring.

Voluntary restructuring or exchange would probably not constitute a credit event. Defaulting now would hinder Greece’s ability to raise finance, and would cause huge stress for its banking sector, a big holder of government debt. It would however constitute a credit event, should the issuer coerce bondholders into agreeing to a restructuring. ISDA, the International Swaps and Derivatives Association based in New York, organises “Determination Committees” which make official, binding determinations regarding the existence of “credit events” which may trigger obligations under a credit default swap contract.

According to the Depository Trust & Clearing Corporation, there was $3,530.2 million net notional outstanding in Greek sovereign debt CDS as of November 4, 2011. This figure was as high as $9.44 billion in December 2009.

Among the reasons for this fall: profit taking and the worry among CDS buyers that talk of restructuring in the form of the more favoured Greek voluntary exchange will not trigger a CDS credit event.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. The company and/or the author may hold positions in any securities that might have been mentioned in this report. Curmi and Partners Ltd. is a member of the Malta Stock Exchange and is licensed by the MFSA to conduct investment services business. Should you wish to discuss this article in further detail, feel free to contact the author on 2342 6116.

www.curmiandpartners.com

Mr Micallef is an executive director at Curmi and Partners Ltd.