Greek CDS settlement auction is ‘lifeguards swim only’

The probability of the Greek CDS credit event (trigger) is now quite high. Once the ISDA committee makes their determination (and with CAC, they have to call it an event), the CDS settlement begins. Modern CDS are cash settled rather than via "physical". In the past the protection buyer often delivered the defaulted bond (usually could be any eligible pari passu bond from that name) in return for par payment from the protection seller. These days the settlement is done via auction of the defaulted bonds that is used to determine the bond "recovery value". That means if you hold a Greek bond and also hold protection you may still have some basis risk.

If your bond is worth say €30 and you also hold the CDS, you would expect the total value of the position to be around par. Suppose you want to hold on to your bonds (post-PSI) instead of delivering them into the auction. If the auction ends up with a recovery value of €32, the CDS will only pay you €68 (instead of 70), and now you end up with €98 instead of par. There is some basis risk between where your bond is marked and where the CDS recovery is established. That's why in preparation for the auction, some investors are using "recovery locks" - swaps that pay the difference between the expected and and the actual recovery levels once the auction is completed.

IFR has a great write-up on the topic:

Recovery locks only tend to trade in the run-up to a CDS auction. Some traders prefer to use these instruments to cover their residual risk in order to avoid volatility in the CDS market going into an auction. Five-year CDS on Greece has also pushed out over the last week by four points to 72 upfront to take into account the higher than expected haircut in the so-called private sector involvement programme that sees investors agreeing to swap existing bonds for new paper.

As discussed earlier, the markets are already pricing in the CDS trigger.

IFR: William Porter, head of credit strategy at Credit Suisse, said the market was already showing general signs of winding down. “The market is liquidating even now at the margin – the open interest is going down, and CDS is priced to an immediate event. You’re effectively conducting the early stages of the auction now,” he said.

Here is the expected timeline for the settlement. The bonds used in the auction to determine recovery will likely be the new, "post-PSI" Greek bonds.

IFR: ...the debt swap will take place on March 12, at which point the CACs will be exercised writing down bonds to 46.5% of face value, and CDS will be triggered. Domestic law bonds should therefore be exchanged for “new” Greek paper before a CDS auction is held, which have traditionally taken at least a week to organise following a credit event decision by the DC [ISDA committee]. As a result, these new bonds should be deliverable into the auction.

This settlement pertains to the Greek law bonds, while there is still uncertainty around €18.5bn of the UK law ("international") bonds. Other uncertainties remain as well, mostly associated with the actual process, given this unusual CDS settlement (vs. say corporate CDS whose settlement is commonplace.) By the time we get to Portugal or Ireland, everyone will be an expert.

IFR: “These auctions are not ‘adults swim only’, they’re ‘lifeguards swim only’ – the market is still learning as we go along. I think the Greek auction will be orderly, but the chance that something really strange might happen can never be entirely ruled out,” Porter said.

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