The determination by the International Swaps and Derivatives Association that Greece officially defaulted on its debt when it invoked its recent legislatively passed “Collective Action Clause” to force investors to take losses is actually good news for the other so-called troubled European sovereigns like Portugal, Spain, Italy and Ireland.
The ISDA determination assures private sector investors that if they buy the so-called troubled foreign sovereign bonds, hedge them with credit default swaps and a Greek style default occurs, they will be paid at or near par value.
If the CDS payout had not been triggered, the private sector investors would view the purchase of such sovereign debt as having significantly more risk, and that would result in a much higher interest cost of that sovereign debt to the issuing countries. In addition, it would throw the whole CDS concept into confusion, potentially impacting even the higher quality sovereigns like, Germany, the U.K., Canada, Australia, and even the U.S.
According to the ISDA, about $3.16 billion of Greek debt is covered by the CDS (4,323 swap contracts). On March 19, an auction will be held which will set the “recovery” value on the Greek bonds. The difference between that recovery value and par will be the payout of the CDS.
For example, if the auction results in a recovery value of 20%, then the CDS payment will be 80%, or about $2.5 billion. This is not a large amount in the context of world markets, and it would be a surprise if any viable CDS issuer will be greatly impacted, although it does appear that Austria’s KA Finanz, the “bad” bank that was created in 2008 when Kommunalkredit Austria AG was nationalized and given all of the “distressed” assets, will be stuck with CDS losses in excess of $550 million which will require the Austrian government to step up with a significant capital injection.
The “non-eventness” of the CDS payouts is a result of the fact that there has been a long lead time for the issuers to adjust their risk portfolios to deal with the likelihood of a Greek default. Over the past year, the amount of Greek debt covered by the CDS has halved. Compare this to the Lehman default of $5.2 billion where there was almost no lead time between the emergence of the Lehman issue and its bankruptcy filing.
