Nobody can deny that when a debtor defaults on its obligation everyone loses, though bankruptcy is part of business. So over the period of time people have learned to do business by taking into account debtor's default probability. That’s why we apply risk premium when extending a loan to a corporate due to inherent nature of riskiness of credit compared to sovereigns. Since (before European monetary union) government owned something which no business can boast of a “printing press”, it can always pay by hiring a few more people who can keep running press (assuming nobody cares for inflation). Earlier sovereign defaults were mostly limited to under developed nation which owed foreign currency debt (Asia 1997, Argentina 2002, Russia 1998 etc), though default by a country belonging to developed nations is a rare event in modern past.
So recent default Greece has genuinely raised the question about the
i) risk free nature of so called developed sovereign debt,
ii) Sanctity of the bond contrct
iii) and utility of CDS as an instrument to hedge the risk
Risk free: It may appear an obvious observation but for the bonds market, Greeks and Germans were the almost exactly the same, risk free!. However, after the financial crisis people will start looking at sovereign credits as an asset class which has different credit risks.
Under the exchange, each EUR100 face value amount of Greek government bonds will be exchanged for new bonds with a face value of EUR31.5 and EUR15 of EFSF ('AAA') notes. Bondholders will also receive a notional EUR31.5 of Greek GDP-linked securities. The implied loss relative to the original terms and conditions of the bonds implied by the exchange is estimated by market participants to be approximately 74%. As per the projection, even after such a big haircut Greece is going to settle between 120% to 130% debt/GDP ratio in 2020, so it is not surprising that gray market quote for new Greece debt instrument is being quoted at a spread of 20% premium over bund translating into 30% default probability in 5 year (given a 60% LGD).
Legal Agreement: Under Moody’s definitions, the following events constitute a sovereign debt default:
» a distressed exchange whereby (1) an obligor offers creditors a new or restructured debt, or a new package of securities, cash or assets that amount to a diminished financial obligation relative to the original obligation; and (2) the exchange has the effect of allowing the obligor to avoid a bankruptcy or payment default in the future; or
» a change in the payment terms of a credit agreement or indenture imposed by the sovereign that results in a diminished financial obligation, such as a forced currency redenomination(imposed by the debtor himself or his sovereign), or a forced change in some other aspect of the original promise, such as indexation or maturity.
By any measure Greece has defaulted on its debt obligation, however a plethora of Policy makers including former ECB President Trichet opposed payouts on Greek CDS on concern traders would be encouraged to bet against failing nations and worsen the region’s debt crisis. “Less than six months ago we had the head of the ECB exhorting that there must be no credit event on Greece.” As per Bill Gross, the subordination of private bondholders to government organizations such as the ECB may have added as much as 1 percentage point to bond yields, Gross said.
Utility of CDS: A committee of credit-default swaps traders will held an auction to settle about $3 billion of contracts tied to Greece after the nation took steps to force investors to participate in the biggest sovereign-debt restructuring in history.
The viability of credit swaps as a hedge for about $257 billion of government debt was questioned after ISDA rejected a request on March 1 to declare whether the swaps were triggered because the restructuring effectively subordinated private investors to the ECB. “It’s important to keep investor confidence in CDS which allows investors to hedge exposure, since lack of effective hedge will affect the ability of sovereigns to issue bonds,” the decision will “restore confidence” in the market. “
So at last we see some sanity in the whole Greek tragedy.
Under the exchange, each EUR100 face value amount of Greek government bonds will be exchanged for new bonds with a face value of EUR31.5 and EUR15 of EFSF ('AAA') notes. Bondholders will also receive a notional EUR31.5 of Greek GDP-linked securities. The implied loss relative to the original terms and conditions of the bonds implied by the exchange is estimated by market participants to be approximately 74%. As per the projection, even after such a big haircut Greece is going to settle between 120% to 130% debt/GDP ratio in 2020, so it is not surprising that gray market quote for new Greece debt instrument is being quoted at a spread of 20% premium over bund translating into 30% default probability in 5 year (given a 60% LGD).
Legal Agreement: Under Moody’s definitions, the following events constitute a sovereign debt default:
» a distressed exchange whereby (1) an obligor offers creditors a new or restructured debt, or a new package of securities, cash or assets that amount to a diminished financial obligation relative to the original obligation; and (2) the exchange has the effect of allowing the obligor to avoid a bankruptcy or payment default in the future; or
» a change in the payment terms of a credit agreement or indenture imposed by the sovereign that results in a diminished financial obligation, such as a forced currency redenomination(imposed by the debtor himself or his sovereign), or a forced change in some other aspect of the original promise, such as indexation or maturity.
By any measure Greece has defaulted on its debt obligation, however a plethora of Policy makers including former ECB President Trichet opposed payouts on Greek CDS on concern traders would be encouraged to bet against failing nations and worsen the region’s debt crisis. “Less than six months ago we had the head of the ECB exhorting that there must be no credit event on Greece.” As per Bill Gross, the subordination of private bondholders to government organizations such as the ECB may have added as much as 1 percentage point to bond yields, Gross said.
Utility of CDS: A committee of credit-default swaps traders will held an auction to settle about $3 billion of contracts tied to Greece after the nation took steps to force investors to participate in the biggest sovereign-debt restructuring in history.
The viability of credit swaps as a hedge for about $257 billion of government debt was questioned after ISDA rejected a request on March 1 to declare whether the swaps were triggered because the restructuring effectively subordinated private investors to the ECB. “It’s important to keep investor confidence in CDS which allows investors to hedge exposure, since lack of effective hedge will affect the ability of sovereigns to issue bonds,” the decision will “restore confidence” in the market. “
So at last we see some sanity in the whole Greek tragedy.
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