The investors who bought credit default swaps as protection against a Greek default must be extremely disheartened.
After some intense deliberation, the International Swaps and Derivatives Association has ruled that the Greek debt deal won’t trigger CDS payments, even though the private bondholders have been coerced into accepting a writedown on the value of their holdings.
How can that be?
At a high level, the main point is that ISDA ruled that debt swap, in which bondholders get new Greek bonds as well as new EFSF bonds, is not yet a credit event. But many investors have also lost confidence in the CDS market because of much more technical issues.
Reuters’ Felix Salmon has dug deep into the drama to help explain why the land of CDS is so murky. In Greece’s case, the big problem is that the debt is being swapped for new bonds issued by both Greece and the EFSF, so there would be so such thing a clean cut default even if ISDA ruled a credit event has occurred. “The new EFSF bonds are obligations of the EFSF, for instance: they’re not obligations of Greece, and they have no place in a Greek CDS auction,” he wrote.
As for the Greek bonds, CDS contracts are paid out on the value of the lowest priced bond trading in the market. If a credit event had occurred, the CDS auction wouldn’t take place until after the current bonds are swapped for new ones.
“When they get paid out on their CDS holdings, people owning protection against a Greek default won’t get paid according to how much money they lost on their old bonds. Instead, they’ll get paid according to the nominal price of the new bonds,” Mr. Salmon wrote.
It’s a very complicated issue, and it's sure to set a new precedent for the market going forward. To really understand the nuances, be sure to check out Reuters' explanation.