Investors who bought Greek default insurance will discover on Monday how much they will be paid, drawing a line under fears that the controversial CDS contracts could spark a widespread banking crisis.
A payout of around $2.5 billion to holders of the insurance contracts will mark the final stage of Greece’s slide into default – an outcome which policymakers once feared could spark the collapse of the currency union.
At the heart of those fears was lingering suspicion that a trigger of credit default swap contracts – vilified for their role in the 2008 financial crisis – could start a chain reaction with unpredictable consequences.
“For a eurozone member it’s the first time this has happened. It’s kind of a big event when you think where we’ve come from. We’ve done a 180 degree turn: the ECB never wanted this to happen,» said one market analyst at a London-based bank.
However, the payout is no longer expected to prompt the chaos once feared by euro zone politicians and policymakers at the European Central Bank – it represents a drop in the ocean of losses investors have already taken on money lent to Greece.
In order to secure a desperately-needed bailout, Greece sliced 100 billion euros off its towering public debt by forcing private creditors to swap their original Greek bonds for new ones worth substantially less.
Despite this move, the rate at which CDS holders are paid out will send a clear signal that the market believes Greece’s huge sovereign debt restructuring has failed to set the country on a significantly firmer financial footing.
“The market view is very much that whilst wiping out 100 billion euros (of Greek debt) is a positive thing, it still leaves them at a new starting point which suggests its going to be very difficult to get their debt back on a sustainable path,» said Gary Jenkins, director at Swordfish Research.
On Monday, buyers and sellers of CDS contracts will take part in a complex auction process where bonds are bought and sold in order to determine a final price, or ‘recovery rate’, for Greek bonds.
Based on this rate, insurance holders will get a cash settlement that compensates them for the loss in face value on the bonds. For more on the auction process see:
Using the current prices of Greek bonds the expected recovery rate is around 23 percent – meaning a holder of $10 million of default insurance will receive $7.7 million from whoever sold them the contract.
The total net payout under this assumption could run to $2.5 billion, based on the net $3.18 billion Greek sovereign CDS contracts outstanding, according to the Depository Trust and Clearing Corporation.
The auction will also create an active market that should give a more accurate picture of the outlook for Greece than do the prices on the new post-swap bonds that are barely traded.
“The auction gives people a chance to dump or buy a lot of paper at a fair price,» said Michael Hampden-Turner, credit strategist at Citigroup.
“The key is the difference in the final price relative to current bond prices… if the recovery rate ends up being 10, for example, that shows people are pretty bearish.”
The final results of the auction are due on Monday afternoon, with final cash payments due to settle on March 26.
So far, the only sign of trouble stemming from the CDS trigger has been at Austrian state-owned «bad bank» KA Finanz, which said it would need support of up to 1 billion euros to cope with losses related to CDS on Greek debt.
Distrust of CDS contracts – blamed for undermining the stability of the financial system during the 2008 crisis – led euro zone policymakers such as former European Central Bank president Jean-Claude Trichet to declare a payout on the instruments taboo.
But much of that resistance subsided as Greece’s economy withered to the point where a restructuring was unavoidable and as understanding has grown about the relatively limited financial implications of triggering CDS.