Sunday, May 15, 2011

Who Loses if Greece Restructures Without Triggering a 'Default Event'?

He who sells what isn't his'n, Must buy it back or go to prison.
-Daniel Drew
Wall Street speculator*

Shorts might get hurt, there are a couple scenarios where they might be forced to cover.**
More probably, longs who think they're hedged with CDS'.

Via a reader, from International Financing Review:

It’s a question that politicians have frequently asked over the past couple of years when lambasting the credit default swap market. Now, as rumours abound that Greece will look to avoid triggering CDS when restructuring its debt, even some of the instrument’s most fervent supporters are questioning its value.

Christopher Whittall reports.

Senior derivatives users, including a member of the board at the International Swaps and Derivatives Association, have warned that the intrinsic value of credit default swaps could be severely compromised if Greece restructured its debt without triggering a credit event.

As a consensus has grown among market participants that authorities will look to avoid triggering CDS when restructuring Greek bonds, market participants have been scrambling to understand the potential ramifications of such a development, with many fearing the worst.

“If there is a restructuring that doesn’t trigger CDS, that calls into question the value of the instrument,” said the ISDA board member. “If you buy CDS and it doesn’t economically protect you as expected, you will question the usefulness of that tool as a risk mitigant, and you’ll be unlikely to ever buy protection again.”
Some dispute this analysis – pointing out that Greek CDS has performed well in hedging the mark-to-market risk of Greek bonds over the past year. While conceding this to be true, other senior derivatives traders are worried that CDS will be devalued in the eyes of end-users if Greece were to sidestep a CDS restructuring event through legal manoeuvring.

It could also have more immediate repercussions for European debt. One London-based sovereign CDS trader said much peripheral sovereign bond-buying had stemmed from negative basis players in recent times (where an investor buys a bond and CDS protection in order to arbitrage differences between the two levels). These investors might not take kindly to Greek CDS not triggering.

“For the last six months, the only Greek bond buying that’s happened away from the ECB has been basis buying,” said the trader. “If you take those guys out of the equation, there would be a lot of sellers coming out of Portuguese and Irish bonds, because they would realise their CDS hedges aren’t good. If Greek debt restructures, then CDS should trigger just in terms of the economics of what it’s meant to do.”...MORE
*That's a bit of understatement. He was probably the first great American speculator. And he knew all the tricks. In addition to his comment on short-selling he applied the term "watered stock" to finance.
In 1867 the owner of the New York Central Railroad, Cornelius Vanderbilt, decided to buy the Erie Railroad out from under Uncle Dan'l.

Drew responded by the tripling the outstanding stock with illegally issued shares.
Good times.

**In 1863 Uncle Dan'l had shorted the New York & Harlem Railroad and then conspired with municipal officials (who were also short) to revoke their previously granted approval for the railroad to lay track from south of Union Square to the Battery. Vanderbilt, had been building a position starting in the $8-9 range because of the railroad's strategic value. The stock advanced to the $50 range after it became apparent that the Commodore was interested in taking control. After the City Council approved the laying of track the length of Broadway the stock advanced to $75. Enter Drew et al.

Vanderbilt absorbed every share the shorts sold to him and ended up with the entire float.
He allowed the shorts to settle at $179.
[there is some dispute whether Drew got caught in the first Harlem corner. -ed]

In 1864 Vanderbilt decided to bypass the aldermen and went to Albany to get the State's okey-dokey.
Uncle Dan got wind of the plan, went long, got the legislators on the bandwagon and ran the stock to $150.
The plan was to sell, go short and defeat the bill.

The stock dropped from $150 to $100 in two days.
This time Vanderbilt bought 137,000 of the 110,000 shares outstanding. Uh oh.
He was so pissed that this had happened again that he said he'd let the shorts out at $1000 but eventually settled at $285.


Large Investors, Price Manipulation, and Limits to
Arbitrage: An Anatomy of Market Corners

Wharton, 2006 (49 page PDF)