18 March 2012

WSJ: Greek deal highlights flaws in default swaps

This article claims that the issue has arisen because Greece used so-called collective action clauses to force a debt exchange on the vast bulk of its bondholders. It gave a package of new securities to its creditors and then tore up the old bonds.

The use of the clauses throws a wrench in the process of determining the size of the payout owed to CDS holders. Usually that payout is determined by the value of the defaulted, old bonds. But, in Greece's case, those bonds have been vaporised. And the new bonds creditors received in the restructuring are only a small part of a package that includes high-quality bonds issued by the eurozone's bailout fund. A new bond thus isn't a one-for-one replacement for an old bond. That leaves potential uncertainty about the amount the swaps will pay.

If the new Greek bonds had different terms—higher or lower interest payments for instance— their prices could be substantially different, changing the amount the default swaps would pay. Ben Heller, a portfolio manager at New York hedge fund, Hutchin Hill Capital, which owns both Greek bonds and CDS, said that means the swaps aren't doing their job. He said that until the problem is fixed, he "will not use CDS as a hedge against credit exposures anymore".

The holders of old Greek bonds received compensation valued at about 23 cents in the bond exchange: 15 cents in high-quality bonds from the eurozone's bailout fund, and 31.5 cents in new Greek bonds that, because they trade at about a quarter of face value, are worth eight cents.

Full article

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