When Greece's nearly $270 billion sovereign-debt restructuring was formally declared a default last Friday, many investors were relieved: Their credit default swaps, a kind of insurance purchased as a hedge against the inevitable collapse of Greek bonds, would pay off in full.
That sequence of events was relatively small change -- only about 1.3 percent, or $3.2 billion, of Greece's bond debt was insured by credit default swaps -- but it has far-ranging implications.
Viewing the default declaration as a precedent could prompt banks, investors and speculators to rush in to buy CDSs as a hedge against bonds tied to other, bigger struggling economies in the European Union, such as Spain, Italy or Portugal. In turn, the bond markets in these countries could plunge further, making an economic crash all the more likely.
But because those EU economies are much bigger than Greece's, a real possibility exists that European leaders will pressure the three countries to make any domestic debt restructuring "clean" -- a process in which no creditor, even one holding a CDS, is paid in full to cover his losses. That would leave banks and investors -- with or without CDSs -- with massive unprotected bond holdings. Such a stark new reality could destabilize financial institutions worldwide.
"If I were looking at buying CDSs, the whole sordid [Greek] affair would make me worried," said John Cochrane, professor of finance at the University of Chicago's Booth School of Business. "There has been a clear, concerted effort by European political powers to prevent CDSs from paying out."
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Through a somewhat opaque process, the International Swaps and Derivatives Association, a group representing more than 800 derivatives-market players from around the world, has final say on whether a nation's debt restructuring qualifies, at least technically, as a default.
In the case of Greece, an ISDA committee last week determined that some private-sector creditors had been forced, through so-called collective action clauses that were adopted retroactively, to exchange their Greek-law bonds for lower-valued, loss-inducing securities. That meant the bond swap wasn't voluntary for all participants, prompting the committee to declare a "credit event" had occurred. Under the ISDA's definition for credit derivatives, a CDS comes into play when a bond restructuring is mandatory.
With the ISDA decision, holders of CDSs will receive the par, or face, value of their bonds minus the recovery value of the new Greek bonds -- about 23 (European) cents on the euro.
It isn't clear yet whether the ISDA's action in response to the Greek deal has led to increased buying of CDSs tied to bonds in other euro zone countries. The first indication of this will come Friday when the Depository Trust & Clearing Corp., a private, New York-based clearinghouse for the securities industry, publishes its weekly report on global CDS exposure.
As of last Friday, March 9, investors had about $22.2 billion in CDSs against $2.5 trillion in Italy's sovereign debt and $14.5 billion in CDS protection on $900 billion of Spain's debt. And with bonds in debt-strapped countries increasingly difficult to unload, CDSs may appear to be the only way for banks and investors to remove escalating risk from their balance sheets.
"Under current conditions, it's much easier to transfer the risk and get that reward by writing CDSs than by selling bonds," the University of Chicago's Cochrane added.
Sounds logical. However, by purchasing CDSs, bondholders may unwittingly be taking on more risk. If the percentage of CDS holdings rises substantially in coming weeks, the increased presence could overwhelm efforts by some countries to work out fiscal problems in a way that averts an all-out collapse of their economies.
That would put Greece's lenders -- the "troika" of the EU, the European Central Bank and the International Monetary Fund -- in a tough spot: Should these supranational institutions stand firm and deflect attempts to identify impending collapses as defaults? Or should they cave in, as they did with Greece?
Most experts believe the troika will be far less flexible in handling future crises.
"Nobody cared about [Greece]," said Diego Ferro, partner and portfolio manager at Greylock Capital Management LLC. "At no point in time did the troika think, 'No, don't trigger [a default] because there will be some kind of domino effect.' If it was systemically important for it not to have been triggered, then it wouldn't have been."
Europe's aversion to declaring a debt default isn't driven solely by a potential surfeit of outstanding bonds and CDSs, and the resulting impact on global markets. The troika is also motivated by fear that a default carries the taint of wholesale bankruptcy and economic failure, which is much harder to rebound from, particularly in terms of investors' perception, than an orderly restructuring of debt.
"Europe wanted to have it both ways -- to have the private sector take a loss and avoid paying out on CDSs. ... They wanted to avoid the appearance of being in default," said David Beim, a finance and economics professor at Columbia University. "Europe's leadership wants to create this image that a country in the EU can't default, which is ridiculous."
Of course, the troika will be just one party in any future European economic negotiation and, as was amply shown in Greece, the ISDA can be a powerful adversary.
"While [the Greek discussions] were going through, people were saying, 'It's not working; CDS isn't triggering.' But actually, last week we triggered it when something actually happened," David Green, ISDA general counsel, told Bloomberg Television. "And I think that gives people faith in the process."
Still, European and IMF officials enjoy the greatest leverage in any deal: It's their money that will be needed to bail out a failing country. As such, most observers believe that if official pressure is going to be applied on politicians and the ISDA to avoid a default, rendering CDS protections virtually worthless, European fiscal authorities will get their way. After all, these officials also regulate many of the institutional investors the ISDA represents.
"There is the question of the ISDA; they're supposed to be the arbiters of default," said Jerome Fons, executive vice president at Kroll Bond Ratings. "But could they be subject to political pressure?"
That's an easy question to answer, said Greylock's Ferro: "In general, I think that we can see that certain regulators are not against bending the rules when something is systemically important."