I’ve been following the Greek Debt Negotiations and it’s been a really fascinating story. It’s amazing how much the derivatives market has complicated the process.
Normally when a country defaults, a debt exchange often takes place. That is the original creditors would trade in their old debt for new debt with new payment terms and usually a reduction in the amount of principal on the coupon (“haircut”). A creditor will usually agree to an exchange like this if it thinks that it won’t get paid any other way, and collecting 50 cents is better than getting nothing.
There are several types of creditors: bilateral (individual countries), multilateral (e.g. World Bank and IMF), commercial banks, and other private investors. Each of these creditors have different incentives to settle with Greece and move on from the default. Some are more willing than others. In particular, some private creditors have had their situations complicated by their hedging positions.
Enter the credit default swaps…
So as explained earlier, a credit default swap (CDS) can be thought of similar to a type of insurance policy, when the debtor defaults, the creditor swaps positions with the CDS counter-party and is effectively made whole by the counter-party.
Private sector creditors are being represented by the IIF, Institute of International Finance, a global association of financial institutions that has the incredibly difficult challenge of representing the private creditors in the negotiations.
Here is where things start to get complicated, every creditor has a different agenda. And based on how the debt agreements are structured (specifically whether or not there is a pari passu clause or collective action clause) some, all or most of the creditors are required to approve a deal. Given that a private creditor could withdraw its permission to allow the IIF to negotiate on its behalf, the IIF is tasked with balancing many competing interests.
What are those competing interests? Well it depends on who is holding the debt.
If its a commercial bank with significant interests in doing business with the government of Greece or doing business in Greece, they are more likely to go along with the consensus and settle the matter as quickly as possible in order to preserve the relationships with the government.
If its a hedge fund or distressed debt fund who purchased the debt on the secondary market, it depends on the price they paid and their individual expectations of IRR which will dictate how hard they negotiate.
If its a pension fund (or a trust) with fiduciary obligations to its beneficiaries, they will have competing interests to ensure that they do not violate their obligations and get the best deal possible.
And it gets really complicated when any of these parties holds a credit default swap on the debt. Because if they hold a CDS, they may have an incentive to settle at a lower amount in order to trigger a default under their agreement and then be made whole. So instead of settling for a 50% cut or a structure that doesn’t technically qualify as a default, they may be incentivized to actually structure a deal which is likely to trigger their protection.
Which begs the question, when is a default a default in a CDS? This is where things continue to get murky because the CDS market is unregulated, each contract may have differences in it. Now its most likely the case that a 50 or 60% haircut may be enough to trigger a technical default and initiate the CDS protection; however, many of the private creditors don’t want this because they are still trying to determine what their potential exposure is on the CDS side of things. It’s likely that many of the creditors are on both sides of the swaps or represent clients who are on the other end of a swap. So even within a bank, there may be conflict on which way to negotiate. And to make matters worse, the CDS counter-parties, who aren’t readily identifiable, don’t have a separate seat at the table.