Greek Crisis Raises New Fears Over Credit-Default Swaps

Greece’s debt restructuring is dragging credit-default swaps back into the spotlight.

The last time this financial instrument was on the global stage was in 2008, when the American International Group’s

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[AIG  Loading...      ()   ] credit-default swaps brought the insurer, as well as the wider financial system, to the brink of collapse. A.I.G. had unique weaknesses, and regulators have started to overhaul the credit-default swap market since 2008.

European policy makers have nonetheless looked warily at credit-default swaps, at least until recently, while they structured the Greek rescue over the last six months.

They aimed for a voluntary debt exchange that would not initiate the default swaps, fearing that payments on the swaps might set off destabilizing chain reactions through Europe’s financial system.

But now, with Europe’s $172 billion aid package for Greece, it appears that the nation is going to take a step that substantially increases the likelihood that its swaps take effect.

To get maximum debt relief, Greece needs to have as many qualifying bonds as possible join the restructuring.

Toward that end, Greece may insert something called a collective action clause into bonds issued under Greek law. If the clause is inserted and then invoked, all bondholders will be forced to take a haircut, making the exchange involuntary. That would set off the default swaps.

The official decision on whether a default swap has been activated is made by the International Swaps and Derivatives Association, an industry body.

“I have very little doubt that they will be triggered,” said Darrell Duffie, professor of finance at Stanford.

The Greek government said Tuesday that it was sending a bill to Parliament that, if passed, would insert the clause into bonds issued under Greek law, which make up more than 90 percent of the country’s bonds. (Other Greek bonds were issued under English law.)

Some chance remains, however, that the exchange could be done voluntarily, avoiding a default swap event. That outcome would most likely prompt a torrent of criticism that the swaps did not cover holders against losses, as they were intended to.

“The whole nature of the C.D.S. contract would be called into question,” said Richard Portes, professor of economics at the London Business School.

In response, supporters of default swaps say bondholders can choose to hold their bonds and not put them in the exchange. The moment Greece fails to make a payment on at least $1 million of bonds, the default swaps will come into play, they say.

“If one investor had $1.1 million of debt and decided not to tender in an exchange, and the debt issuer stopped making payments on that debt, it would trigger a credit event,” said Steven Kennedy, a representative for the I.S.D.A.

The swaps will also come under heavy fire if there is any indication that activating the Greek instruments is leading to stress in the financial system. Nearly $70 billion of default swaps are held on Greece, but the net number is only $3.2 billion, once the instruments that sell credit protection are subtracted from those that bought it. For Italy, the numbers are far higher, with $314 billion in total and $22.5 billion net.

European leaders have not explicitly identified where they feel any default swap risks in the region may lie. A stress test of the region’s banks last year did not reveal large, unhedged exposures on swaps written on government debt. In nearly all cases, banks that sold insurance also bought a similar amount, which balances out their exposure.

Still, there may be cause for concern. This system can break down if a large bank collapses, because counterparties might not be able to collect on the failed bank’s default swap obligations.

“Counterparty risk has been the great amplifier,” said Walter Dolde, associate professor in the School of Business at the University of Connecticut. “Sometimes an avalanche starts with a snowball.”

The default swap market’s defenders say counterparty risk is mostly eradicated with the practice of posting margin. If a bank owes money on a trade that is still open, it has to post cash or Treasury bills to the counterparty of an amount that is equal to, or even above, the amount that is owed. As a result, if it collapsed, the counterparty could keep the margin payments. A.I.G. was for a while exempt from posting margin on many of its swaps, which is one reason it became a systemic risk.

“The fears about the market are small potatoes,” Professor Duffie of Stanford said.