CITI: Failure To Trigger Greek CDS Could Cause The Whole Euro Bailout To Fall Apart


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There’s an ongoing debate about whether or not credit default swaps (CDS) on Greek debt will be triggered in the event of the proposed 50% writedown.  The crux of the debate seems to rely on whether or not the writedown is “voluntary.”However, Citigroup’s Willem Buiter thinks failure to trigger these CDS would be catastrophic.

First, he argues that a 50% writedown is indeed a credit event worthy of triggering the CDS.

…It would pass the ‘duck test’: “If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck.” Specifically, such an event could be characterised as ‘voluntary’ only in the army sense of the word voluntary (“I need three volunteers: you, you and you!”). Were someone to hold a gun to my head I might ‘voluntarily’ hand over my wallet, but in a court of law this event would probably not be determined to be a voluntary gift, but armed robbery instead.

Failure to trigger would all but discredit the entire CDS market.

It is possible that some exceedingly clever lawyers and PR specialist could convince the relevant Determinations Committee of ISDA that a 50% or 60% haircut need not indicate a credit event, but, were this to occur, it would probably do more damage to the EU sovereign debt and CDS market than would have occurred had a credit event been declared and CDS triggered. The reason is that a failure to trigger CDS when, according to common sense, economic logic and commercial rationality, CDS ought to be triggered, would impair the value of CDS as an asset class. In the Euro Area there are more than a trillion dollars’ worth of sovereign CDS outstanding. Market participants (pension funds, insurance companies, banks, asset managers and hedge funds) that have bought CDS as insurance against Greek default would be denied the pay-out on their insurance policies. The response might well be a rush to unload the underlying assets of these Euro Area CDS, the sovereign debt of all vulnerable Euro Area member states. This would be rational contagion par excellence – and it would have been triggered by a failure to trigger CDS on Greek sovereign debt when the sheer magnitude of the write-down on the Greek sovereign debt would have made a credit event the reasonable, logical outcome.

Even worse, it could completely destroy the success of the current proposed plans to leverage the EFSF.

What is more, avoiding triggering CDS when the fundamentals suggest they ought to be triggered, would further erode credibility of EU/EA policymakers. That credibility is already weakened by the slow and piecemeal response to the crisis. But some of the support measures considered currently make a further erosion of policymaker credibility especially problematic. For instance, the success of the proposal that implies that the EFSF provided (first-loss) guarantees for new issuance of EA sovereign debt in the primary market relies on the belief of market participants that such guarantees would actually be honored in the future. Avoiding CDS payouts on technical or legalistic grounds could make any such assurances less credible. And even the original EFSF relies on guarantees by EA member states. Any action that undermines the credibility of promises by EA member states or the EFSF to honour guarantees thus has the potential to unravel the entire EA support architecture.

Buiter believes triggering these CDS would be a much better option.  He also argues that the event would not amount to chaos in the financial markets. “The risk to financial stability this creates, through contagion and other channels, is manageable with existing institutions and instruments.”  Here’s some more detail:

Fundamental contagion following a triggering of Greek CDS, that is, contagion through interlinkages of exposures and through other financial or commercial interconnections, would likely be a matter of comparatively little importance in the case of Greek CDS. The amount is limited ($74bn gross, less than $4bn net) and the collateral backing of CDS contracts and the rigour with which they are marked to market and are subjected to margin calls have improved since Lehman days. Unpleasant surprises can never be ruled out, particularly as the high degree of interconnectedness of the financial system and the size of the gross exposures have the potential to create chains of events that magnify initial impacts. However…the fact that any Greek credit event must surely be anticipated much reduces the risk of pernicious domino rounds of insolvency.

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