Sovereign Bailouts and CDS Restructuring Triggers


On July 21st, the International Monetary Fund and European Union agreed to a second bailout package for Greece amounting to some €109 billion, subject to the beleaguered country implementing structural reforms and meeting specified fiscal targets. This is in addition to the €110 billion package launched in May 2010. For investors in the private sector, the new plan involves a voluntary restructuring of Greek debt, whereby investors voluntarily elect to exchange existing debt into four instruments. This exchange will result in a 21% net present value loss on private investor debt holdings (assuming a 9% discount rate) and an extension of the average debt maturity from six years to 11 years. The private sector contribution to the plan is estimated to be worth some €37 billion, with a target of 90% of private investors participating.

Rating agencies have indicated that they intend to treat the plan as a “selective” default. However, as discussed in greater detail below, the voluntary nature of the private sector involvement means that credit default swaps (“CDS”) are not able to trigger based on the plan.[1] This, in turn, has called into question the value of credit default swaps, at least with respect to sovereign reference entities.

CDS protection payments are triggered (subject to the satisfaction of certain other conditions) upon the occurrence of a “credit event,” including a “Restructuring.” Under the 2003 ISDA Credit Derivatives Definitions, which govern virtually all CDS transactions, a Restructuring is generally defined to include: (i) a reduction in either the interest rate or amount of interest or principal payable on an obligation; (ii) a postponement or other deferral of the payment of interest or principal on an obligation (including an extension of maturity); (iii) a change in the ranking or priority of payment of an obligation, resulting in its subordination; or (iv) a change in the currency of the obligation to other than a permitted currency.[2] However, any such event must “occur[] in a form that binds allholders” (emphasis added) of an obligation for a Restructuring to take place. The exchange of privately-held debt under the plan will be voluntary, and so, will not be binding on all holders.

The triggering of Greek CDS, if it were to occur, would be highly unlikely to have systemic implications.[3] Nevertheless, it appears that the rescue plan was intentionally structured to not result in a CDS credit event, perhaps to dissuade continued speculation in European sovereign CDS.[4] Certain commentators have argued that the restructuring plan has flipped market expectation on its head and have questioned the continued value of sovereign CDS. However, others insist that CDS products continue to work as contemplated, pointing out that private investors electing not to participate in the voluntary restructuring that continue to hold the original debt remain protected against a “hard” credit event (such as a payment failure or mandatory restructuring) under CDS contracts where they have bought protection. The International Swaps and Derivatives Association, Inc., the primary industry group for the derivatives marketplace, has indicated that it intends to gauge market sentiment in the wake of these developments and may explore changes to the definition of Restructuring.[5]

[1] Despite the controversy surrounding the Greek plan, it is sufficiently clear that this is the case under the existing regime governing CDS transactions. Indeed, as of the date of this publication, not one market participant has even bothered to ask the relevant regional determination committee (i.e., the committee charged with making certain decisions for CDS transactions with respect to reference entities in Europe) to decide whether a Restructuring credit event has occurred with respect to Greece in connection with the plan.

[2] Note that three separate types of this credit event exist: standard Restructuring (known as “Old R”); Modified Restructuring (known as “Mod R”); and Modified Modified Restructuring (known as “Mod Mod R”). Unlike Mod R and Mod Mod R, Old R does not limit the maturity of what a buyer of protection may delivery in connection with a credit event. Old R typically applies to CDS having Western European sovereigns as reference entities.

[3] As of July 1st, according to data from Depository Trust & Clearing Corporation, the aggregate net exposure for sellers of credit protection on Greek sovereign debt CDS was $4.8 billion (or just 1% of the government’s outstanding debt), without taking into account any recovery value or collateral. Moreover, the vast majority of CDS exposure is collateralized, either partially or fully.

[4] European governments have long been concerned about the economic implications of speculation in sovereign CDS markets. For additional information on this topic, please see DMIR March 2010.

[5] See Katy Burne, Swaps Group Weighs Revamp of Triggers on Default Insurance, Wall Street Journal (Aug. 3, 2011).