On Monday, we’ll finally know what amounts will be paid out to those who bought credit default swap protection on Greece, following last week’s credit event.
Which means it really is worth knowing how the payouts will be derived. In short though, they will be determined by the results of an auction to find the recovery price of old Greek bonds. This particular auction promises to be extra exciting because Greek bonds are a rather diverse bunch of assets. Much more on this shortly.
Let’s back up a bit first. Greece, as a credit, deteriorated in a slow-motion train wreck over the last couple of years, so CDS spreads had time to widen out accordingly, andrelatively gradually:
With all the uncertainty about CDS being triggered or not, as well as mounting profits and losses for those on either side of contracts, a lot of counterparties decided to to exit their positions. There is $3.2bn of net notional still outstanding, which is a lot less than existed two years ago, as this chart using DTCC data shows:
But for those who stuck by their positions rather than cashing out, the final payments made under the contracts will be dictated by an auction process.
The results of said auction will be publicly available on the CreditFixings site. The whole thing takes a day, so remember to pack deck chairs and popcorn.
FT Alphaville has previously written about why auctions exist, why they were necessary for the CDS market to grow, and the exact mechanics of them.
As it pertains to Greece’s auction, there are issues around deliverable bonds, given the bond swap (aka, PSI). And we’re going to come back to this in the below.
The as-brief-as-we-can-make-it auction primer
Please go back and read our previous post on mechanics if you want all the excruciating detail, but for those who are time-constrained…
CDS settle in cash. Protection sellers need to know how much to pay the protection buyers, and this amount is determined in a credit event auction.
The auction itself does not involve CDS trades being closed out. Instead it involves trading in the bonds of the defaulted entity. The idea of the auction is therefore to discover what the fair price of the bonds is, and use that price to determine the cash settlement amount for CDS.
The list of bonds that may be traded in an auction is determined in advance, and is called the “deliverables list”.
For Greece there will be many deliverables, including the new Greek bonds (that those participating in the swap were recently given), as well as various foreign law bonds that are still outstanding (not yet CAC’d and maybe never shall be). There are also bonds from state-owned entities like Hellenic Railways, National Bank of Greece and EFG Eurobank. In fact, the initial list of deliverables has already been published.
So the auction will determine a general clearing price (P) for whatever the cheapest bonds from all the bonds on the list are. Usually, with a defaulted entity, i.e. bankrupt corporation, all of the bonds within the same tier (e.g. senior unsecured) trade at the same price since the recovery is likely to be identical between bonds of the same rank.
In this respect, some Greek deliverable bonds are going to make this an awfully interesting auction. For example, with some of the foreign law bonds there is some speculation that some issues may actually recover their principal. That being the case though, they are unlikely to be used in the auction, since they won’t be as cheap as other bonds on the deliverables list. And what price for the state-owned entities’ bonds? Chances are, the uncertainty around it all will mean a potentially low-ball settlement price.
In any case, the auction sets the general price, and the payout to CDS protection buyers will then be as follows:
Payout = Notional of CDS * (100-P)
For example, a buyer of $10m of protection on Ecuador would have gotten $6.8625m, as a result of its credit event auction in 2009, which was held after the sovereign failed to make payments on its bonds:
A credit event auction has two stages. In the first stage, the participating dealers do two things:
- Submit bids and offers for a pre-determined quote size — for the Greece auction, the quote size will be €5m.
- Declare whether they want to buy or sell bonds in the auction, and if so, how much.
Here’s what the bids and offers looked like in Ecuador’s auction:
From these an initial consensus price is established – the Inside Market Midpoint (IMM).
Here’s what the demand was to buy bonds and the supply was from those banks that wanted to sell:
The sum total of bids from dealers (who want to buy) is more than the sum total of the offers from dealers (who want to sell). Taking a look at the little summary table:
What this table tells you is that demand outweighs supply. But also $145.848m is already matched and ready to trade between happy buyers and sellers.
Now onto the task of finding more sellers in order to satiate the $77.482m of excess demand. And that’s what the second round of the auction is all about.
The above tables for Monday’s Greece auction will be available at 11am London time.
In round two, dealers submit “limit orders”, i.e. a quantity of bonds they are willing to sell and a price for them. They can, of the most part, submit as many different limit orders as they like and may be acting on their own account or on behalf of clients.
Also, the offers from the first round are brought forward at the standard quotation amount, which was $3m for Ecuador:
As per the notes at the bottom of the table, the lines with ** by them were from the first round. Everything else is new. The dealers have half an hour to submit limit orders.
After that, the prices are ordered from low to high, and the excess demand of $77.482m is filled with the cheapest supply first. The price at which the final drop of excess demand is satiated by is the final price (P), and all trades settle at that single price.
In the Ecuador auction the excess demand was met by four limit orders. Since they all came in at the same price, they were all partially filled, hence the ^.
The information for the second round of the Greece auction will be published at 3:30pm London time.
Back to the deliverables issue before we leave you though. We were talking to credit über-geek Michael Hampden-Turner at Citi about this: the participants of the auction will not know exactly what bonds on the deliverables list they will end up with. Given that, will there be physical settlement requests to buy, or just a lot to sell?
And given that in the first round, banks’ bids are actionable, they are likely to be pretty low ball. Ditto the second round if the net open interest is to sell, and it seems more likely than not that it will be.
All of which means that the price may be rather on the low side, and hence CDS protection buyers will get bigger payouts — at the margin anyway.
Until Monday then.
Related links:ISDA unveils initial Greek deliverables list – IFR
Hellenic Rep CDS Credit Event Auction – Credit Fixings
Shhh! Isda cabal is acting in a predictable way. - FT Alphaville
Ok guys, hands up who booked the weird Greece CDS trades… - FT Alphaville
Hellenic Rep CDS Credit Event Auction – Credit Fixings
Shhh! Isda cabal is acting in a predictable way. - FT Alphaville
Ok guys, hands up who booked the weird Greece CDS trades… - FT Alphaville
Keine Kommentare:
Kommentar veröffentlichen