Four years ago, in March 2007, three months before the start of the credit crisis, I tried to make my voice heard regarding the potential impending crisis in the credit derivatives world. I have written extensively about this in earlier entries, see Who listens to academics?, and my message from that blog can be summarized with the passage:
…..I am just not convinced that the typical credit derivative is either (i) traded in a satisfactorily liquid market, (ii) well defined, or (iii) understood by all participants……
Most of you know that the first and last points have come true (clearing houses to replace OTC trading in CDSs and investors such as the commune of Narvik in Norway deafulting on their CDOs) but the second point has not been raised very much in media. The point was raised in my attempted newspaper article however:
…..Moreover, there is evidence of the legal/operational interpretation of the contract-details occasionally being open for discussion. For instance, the exact definition of what should count as a credit event is sometimes debated, and in some cases the CDS owners have even seen their contract suddenly become worthless due to an unexpected total debt-repayment by the underlying firm!…..
Let us fast forward to May 2011! Now, the kind of problem discussed above, exactly, is potentially faced by the CDS owners that have bought protection against a Greek default. In fact, the so-called voluntary debt restructuring that EU-officials talk about might not trigger an actual default in the CDS-contract! At least that is a risk that is dicussed in the CDS community. And that would mean a zero pay-out to the insurance buyer and a disqualification of the entire sovereign CDS market! Ecco, all my three pre-crisis predictions have come true!
I find the whole thing slightly worrying though and I wonder how the CDS traders treat this “problem”. At the moment the Greek sovereign 5Y CDS spread is 13% and one asks oneself how high the spread would be without the risk of a non-payment? I must also question the logic behind the term “voluntary restructuring” and the extent to which such an event is really “voluntary”. I mean, if this was voluntary, why would not bond holders in general gladly extend the maturities of their bonds without any compensation as soon as they have the possibility to do so (such a maturity-extension is most likely what such a restructuring would mean)? To me, such an event is not voluntary at all and simply equal to a credit event!