CDS and Debt Restructuring: Does the Existence of Credit Derivatives Make Restructuring Harder? By Nouriel Roubini and David Nowakowski Apr 21, 2011 12:00:00 PM | Last Updated

EXECUTIVE SUMMARY

Credit default swaps (CDS) may influence efforts by sovereigns and corporations to avoid default and conduct market-based debt exchanges, as RGE has previously explained.

Hedged (or overhedged) bondholders may have an incentive to see a default occur, rather than maximize the recovery value or restructure debt successfully.

A sovereign default, or a debt exchange offer that triggers CDS, may negatively affect the condition of local banks that sold CDS protection and cause defaults to their counterparties.

RGE’s view is the risk of an exchange offer failing because of the existence of creditors with CDS protection is modest and a properly planned sovereign debt exchange offer—that does not use domestic legislation or collection action clauses (CACs) to change the bonds’ terms—need not trigger CDS, and probably wouldn’t be thwarted by the derivatives market. Thus, successful and socially beneficial debt exchange offers are unlikely to be prevented by the existence of CDS protection.

Policy makers must be aware of these risks, and clarification on what will or won’t constitute a CDS credit event would be desirable, but is unlikely ex-ante from governments, the International Swaps and Derivatives Association (ISDA) or the European Financial Stability Fund (EFSF).

Introduction

There are legal and economic considerations to be made in discussing whether the existence of CDS makes debt restructurings more difficult, both for sovereigns and for corporate firms. This issue is very important as some have argued that the existence of CDS markets may lead bond creditors of a sovereign or a corporate firm that is insured against default via CDS protection to vote against an otherwise socially beneficial debt exchange offer and thus prevent such a debt exchange from succeeding. In the context of sovereign debt distress, the issue could become relevant if Greece—or other eurozone (EZ) sovereigns such as Ireland and Portugal—were, as is possible in the future, to consider orderly restructurings of their debt. Will the existence of CDS scuttle their ability to implement orderly sovereign debt restructuring?

It is known that voluntary debt exchanges would be one method to avoid the disruption of an outright default; but the CDS market may affect the success and/or outcome of such an effort. While a carefully conducted debt exchange process could avoid triggering CDS—as

policy authorities may want to protect banks that have sold protection—an ISDA-sanctioned process might deem this debt exchange a “credit event” if the process is deemed coercive.

Conducting a market-based re-profiling of debt that puts countries’ debt-sustainability on a sounder footing is already an extremely challenging aim, but one that is preferable to endless bailouts or disorderly defaults. However, issuers, regulators and market participants should carefully investigate the fallout that their actions could inflict on derivative markets and possibly systemic participants like domestic and foreign banks.

Issuers may also be worried about “empty creditors” who have hedged their exposure with credit derivatives, thereby preventing a restructuring, preferring a default. There is anecdotal support for this notion: In several corporate cases, the existence of CDS made debt exchanges more complicated. Still, the evidence is not overwhelming and the amounts of outstanding

CDS on developed markets sovereign bonds are generally small relative to the bond markets themselves.

Legal Issues

Will a debt exchange offer trigger the CDS? Rating agencies regard such debt restructurings as credit events (for example, Uruguay’s 2003 exchange resulted in S&P and Fitch assigning SD and D ratings for two weeks, after which large upgrades were granted) as they occur under threat of default and result in investor losses or maturity extensions.

But the legal definition is different: The trigger for CDS is a credit event defined under ISDA terminology. This includes the following:

1. Failure to Pay: Any scheduled principal or interest that is unpaid; this is what is usually considered a “default,” though a grace period of around 30 days usually applies.

2. Repudiation/Moratorium: Declaring any of the obligations referenced by the CDS invalid, and actually refusing to honor those payments (i.e. restructuring or failing to pay).

3. Restructuring: Altering the principal, coupon, currency, maturity or seniority as a consequence of credit/financial deterioration, in a form that “binds all holders.”

It is the third possibility that may apply to an exchange offer and trigger the CDS, as opposed to voluntary liability management operations that are not considered credit events. An exchange offer would be considered a “restructuring” credit event if: a) Domestic legislation were be used to change the financial terms of the old bonds or subordinate them relative to the new bonds; or b) CACs were to be used to change the financial terms of the old bonds and thus bind in all bondholders via majority enforcement clauses. But if an exchange offer does not resort to changes in domestic legislation or CACs it would not be considered a “restructuring” credit event and thus would not trigger the CDS payout.

The recent proposal of the European Stability Mechanism (ESM) as a successor to the EFSF envisions it gaining preferred creditor status while an insolvent country “will have to negotiate a comprehensive plan with its private creditors,” but offers no clear guidelines on whether this will be done through default, repudiation, restructuring or exchange offer with or without CACs. Depending on how a restructuring occurs, the CDS may or may not be triggered; at this time, it looks like market participants will have to wait for events to unfold to find out.

Some CDS contracts may explicitly include “obligation default/acceleration” (a breach of the covenants and pledges that results in bonds being capable of becoming, or actually becoming, declared due and payable) as a credit event, and if such actions do in fact cause acceleration, then it is likely that CDS will be triggered under the “restructuring of cashflows” clause. One example where this came up was Venezuela’s threat to leave the IMF, which would have been an event of default under its bond contracts. Recently, the ISDA resolved that the seniority of Irish government bonds has not been subordinated to IMF loans. However, that such questions arise demonstrates the potential unpredictability of this still-nascent market. A corporate example (Cemex) also showed that interpretations of what constitutes a “restructuring event” can be contentious. A drawn-out debate concluded that what appeared to be a refinancing, involving no missed payments, was in the end deemed a restructuring and a credit event.

ISDA’s research explains why restructuring would not be a CDS credit event as follows (Mengle, 2009); while the focus here is on corporate bonds, much of the reasoning applies to sovereigns as well:

The advantages of restructuring outside bankruptcy include a more favorable recovery rate than is typically experienced within bankruptcy (Altman and Karlin 2009[1]) as well as avoidance of the often substantial administrative and legal costs of going through the bankruptcy process (Altman and Hotchkiss 2006, chap. 4). …out-of-court restructurings … have not triggered credit default swaps. The primary reason is that the ISDA documentation provides that a restructuring credit event must bind all holders; the terms of the

restructurings mentioned in this article, in contrast, were binding only on those investors that accepted the terms (ISDA 2003, Section 4.7; Altman and Karlin 2009).

In the Greek sovereign case, RGE’s view is that if appropriately designed, a debt exchange offer would not be considered a “restructuring” if there is no change in legislation to modify

the financial terms of the bonds. That change in legislation is not necessary for a successful exchange offer even if some aspect of it would be useful to increase the probability of a successful debt exchange (especially the terms required for acceleration). In the Greek case,[2] existing local-law bonds do not include CACs; thus, an exchange offer would not occur via the use of CACs and would thus not be considered a credit event for CDS purposes. Greece’s international bonds issued under English law do contain provisions for changing payments via bondholder meetings and extraordinary resolutions requiring 75% approval; even though such a re-profiling doesn’t violate the terms and conditions, it would be considered an event of default under the ISDA definitions, and CDS payments would get triggered. Whether an issuer chooses to use this power, or use other “exit consents” to encourage or coerce holdouts[3] without triggering CDS, is a choice to be made when constructing the offer.

Reforms adopted by ISDA and market participants are an acknowledgement that there are grey areas and that events may play out in untested, unanticipated ways. Under the Big Bang protocols, there is now a procedure by which a determination committee is the ultimate arbiter of whether a credit event has occurred or not. The members of the committee include many of the major Wall Street and European banks as well as several of the world’s largest asset managers; conflicts of interest abound. It is quite possible that even if no payments are missed, an exchange offer imposing NPV losses that is viewed as coercive and resulting from credit deterioration is deemed a de-facto restructuring, even if strenuous efforts are made to avoid this. The exception to a restructuring being deemed a credit event, according to ISDA’s practice notes, is “to protect against triggering a Restructuring where a Reference Entity’s credit quality [or market condition] has improved and it negotiates new terms with its lenders.”

An extensive discussion of restructuring and CDS is in Verdier’s 2004 paper,[4] in which he explains:

The need of protection buyers for adequate protection is particularly acute when banking regulators allow banks to use credit derivatives as risk mitigation techniques and correspondingly to reduce their capital requirements. Credit event definitions so narrow that they exclude events that cause genuine loss to protection buyers might destabilize the banking system…banking regulators insist that credit derivatives used by banks to hedge credit risk include Restructuring as a Credit Event. European banking authorities have been adamant on this point…

Under the current sovereign debt regime (or absence thereof), countries do not go bankrupt. They also very rarely fail to pay: outright sovereign debt defaults like Russia’s or Argentina’s are the exception, not the rule. Nevertheless, sovereigns frequently encounter severe economic difficulties that make it impossible to continue servicing their current debt level. The normal outcome of such difficulties is the negotiation of a “voluntary” debt restructuring with the countries’ external creditors. Such restructurings often reflect a substantial deterioration of the sovereign’s creditworthiness and, as such, are a manifestation of credit risk. Thus, absent the Restructuring definitions, the protection offered by sovereign credit derivatives would likely be inadequate.

European banks long argued that restructuring is tantamount to default; they may now have to lie in the bed they made.

Economic Issues/Considerations

Let us analyze next the economic considerations involved in determining whether buyers of CDS protection would want to and/or would be able to successfully prevent a debt exchange offer from being successful.

First, note that a buyer or seller of CDS insurance on a sovereign would not be able to vote on and block an exchange offer if he/she has no position in the underlying bonds. Only registered bondholders can participate in an exchange offer, and only if enough of those bonds opposed the proposal could the exchange fail (most, but not all offers require a minimum threshold of participation to take effect).

It is possible, though not trivial, to put on a “basis trade” or CDS-hedged bond trade. Such a trade typically has three legs: (i) The bond of the issuer, paid in cash or funded in repo; (ii) the CDS, traded over the counter with a Wall Street or City bank; and (iii) an interest rate hedge, either through Treasurys or swaps.[5] If CDS prices are below bond spreads, the basis is negative and market participants have an incentive to buy the basis, as the spread on the bonds over swaps exceeds the cost of the CDS hedge. This appears to be the case currently in Greece, as shown in Figure 1, and was widely prevalent in the corporate market during the liquidity crunch following Lehman’s collapse. The so-called arbitrage still contains funding, mark-to-market and counterparty risk, of course.

Figure 1: Negative Basis Exists for Some Greek Government Bonds

Source: Bloomberg, RGE

Second, if the exchange offer is considered a “restructuring” (i.e. a credit event), the protection buyers—who hold the underlying bonds and can vote on an offer—would not wish to block an exchange offer if they bought insurance because they get paid on their insurance regardless of whether the exchange offer fails or not. Protection sellers, who end up with the defaulted bonds or are paid recovery value via an auction process, have every incentive to support a “successful,” value-maximizing exchange, if they happen to own bonds as well as having sold CDS.

Third, if the exchange offer is not considered a “restructuring,” then bondholders who own CDS insurance have an incentive to force a failure of the exchange offer and then

hope that the debtor actually defaults or effects a forced “restructuring” to trigger the CDS insurance. But even in this case, you need to have enough creditors of the sovereign that have insurance to block an otherwise successful exchange offer. This becomes easier if the vote on an exchange offer takes place bond issue by bond issue, where having a blocking interest (say 25%) on a particular issue is easier, especially if the market value of the bonds has already fallen enough. Since bonds without CACs don’t have clauses to impose the outcome of a vote on the aggregate of the bonds (as opposed to a vote on each bond issue), the risk of creditors holding a large, leveraged position of “naked” CDS and a relatively small amount of bonds blocking an exchange offer becomes more serious. Hu and Black (2008) have termed this the empty creditor problem:

Creditors can have greater contractual or legal rights than economic exposure, a pattern we can call "empty crediting." They can hold empty or economic-only positions with no disclosure, not even the limited disclosure required for formal holders of debt. If it becomes important to hold formal contractual rights, economic-only positions can sometimes be morphed to include these rights ("morphable crediting"). In both areas, investors can have control rights yet have negative economic ownership (sometimes loosely called a "net short" position), and thus have incentives to cause the firm's value to fall.

Fourth, in a number of recent corporate restructurings, holders of bonds and CDS insurance were able to block the exchange offer or force the debtor to make an offer more beneficial to creditors because they were holding enough of the underlying bonds to block an otherwise successful offer. According to the Economist (June 2009), this included companies that were pushed into bankruptcy such as Six Flags (amusement parks), AbitibiBowater (paper), General Growth Properties and possibly even GM. In LyondellBassell’s case, a split along American/European lines initially complicated matters. The most egregious case is that of Morgan Stanley and Kazakh bank BTAS, in which the Wall Street firm purportedly pushed a loan into default in order to trigger payouts on its derivatives positions.[6] So, the existence of CDS insurance appears to have constrained the ability to do exchange offers in the corporate setting, although as a self-interested retort to Hu and Black by ISDA’s Head of Research, David Mengle, points out, many restructurings have occurred without problems as well.

Fifth, the financial institutions that sold CDS insurance may not able to pay—and end up defaulting on these contracts—if a debt restructuring does occur. Some of these institutions may be in the debtor country (say Greece) and some of them may be in the creditor country (say Germany, France, etc.). If Greek banks risk going bust when a “restructuring” triggers the CDS, the Greek government may be less likely to engage in such a restructuring as this can lead to serious contagion, with counterparts suddenly finding themselves with exposures that need to be re-hedged. On the other side, the Greek government—unlike the U.S. Treasury in the AIG case—doesn’t have the fiscal/financial resources to backstop its banks if a restructuring triggers the CDS for these banks. So that may be an additional obstacle to a successful exchange offer.

Sixth, the gross and notional amounts of CDS outstanding (see DTCC’s website, http://www.dtcc.com/products/derivserv/data_table_i.php?tbid=5) are relatively small compared with the total size of European government bond markets. This suggests that holders of bonds that have also bought protection are likely a small fraction of bondholders, and also belies the case that the CDS payouts following a default would be a systemic issue. Counterparty issues are a much larger potential problem, in our opinion, particularly in the case of Irish and Spanish banks.

The table below shows DTCC’s statistics on gross and net amounts outstanding in the top 20+ sovereigns. Even in relatively small markets like Ireland and Portugal, the net amounts suggest that empty creditors and negative-basis trades would be a minor influence.

Figure 2: Outstanding CDS Amounts, Week Ending 3 April, 2011 (top 10 reference entities and other major sovereigns)

Source: DTCC, Bloomberg, RGE

Conclusion

Given experiences in the corporate world and sovereign debt markets, RGE is a strong advocate of orderly restructurings via market-based debt exchange offers (such as the Ford

Motor Company or Uruguay cases) rather than the chaos and greater losses on creditors and debtors that occur in defaults and repudiations (such as in the Lehman, Russia and Argentina cases). By not removing the risk of such mayhem via orderly restructuring, RGE’s Nouriel Roubini and Arnab Das warned that the EZ crisis would not be contained, but rather spread, as indeed it has.

Despite the “restructuring” clause of the ISDA definitions of credit events, the colloquial expression when used in reference to a non-coercive exchange should not apply to CDS; i.e. sovereign debt exchange offers that don’t rely on changes in domestic legislation or CACs would not trigger the CDS. The likelihood that positions of hedged bonds are large

enough to affect the outcome of negotiations or an exchange offer seems small in the case of advanced economies (though emerging markets may face larger challenges). Examples from the corporate world show that this is a valid concern; but the evidence is not overwhelming and many restructurings have proceeded smoothly. If CDS are triggered, this concern is moot, but a new problem may be the liquidity problems faced by banks holding bond and CDS positions, and counterparties becoming suddenly unhedged in the event of default by these financial institutions. Regulators should add such scenarios to their stress tests, and take the CDS

market into account when considering their course of action, but markets may have to

continue to operate under a cloud of uncertainty.

[1] Altman and Karlin, “The Reemergence of Distressed Exchanges in Corporate Restructurings,” 2009. The authors also suggest that distressed exchanges’ failure to trigger CDS is one reason for negative basis, i.e. CDS spreads being below bond spreads.

[2] See Buchheit and Gulati, “How to Restructure Greek Debt,” May 2010, for a look at Greek debt features and the impact of an exchange from a legal perspective.

[3] See Buchheit and Gulati, “Exit Consents in Sovereign Bond Exchanges” (UCLA Law Review, Vol. 48, October 2000), for a thorough discussion.

[4] See Verdier, “Credit Derivatives and the Sovereign Debt Restructuring Process” (Harvard Law, 2004)

[5] Hedging interest-rate risk on high-yield and distressed securities is a tough problem in itself, as junk bond prices, unlike high-quality bonds, often show little correlation to government bonds and swaps.

[6] See ISDA DC request, BTAS conference call, analysis by FT’s Tett and Buiter.

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