Will the ISDA Decision Cause Another MF Global?
The ISDA decided that the 50%+ haircut that Greek bondholders will take does not constitute a default. Will their decision cause another MF Global type of collapse?
Background
The Internation Swaps and Derivatives Association is a global trade association the sets the rules for OTC or Over the Counter derivative transactions. CDS sold by banks as insurance against default by Greek bonds are OTC derivative transactions. The Greek government cannot meet the interest payments on the bonds they've issued. European Union officials recently brokered an agreement that stipulated that holders of those Greek bonds would agree to take a 50%+ haircut on the principal value of the Greek bonds they are holding. In addition, the Greek bonds holders will swap their existing bonds for new bonds that would effectively reduce the amount of interest the Greek government would pay.
Last Week's Action by the ISDA
The ISDA was called on to rule whether this agreement - where the principal value of the bonds would be reduced and the interest payments restated - was in fact a default. They said it was not a default.
(If someone owed you $1,000 and agreed to pay you back in 10 installments of $100 over 10 week and then told you that they would only pay you $500 in 10 installments of $50 over 10 weeks, you could reasonable tell them that they were defaulting on their obligation.)
The members of the committee that decided this was not a default were banks. Some of these banks (perhaps all of them) had issued CDS against Greek bonds. They would have lost billions if they had to pay up. So they decided there was no default; therefore they don't have to pay up.
In order to try to deflect criticism for an obvious conflict of interest, the put in weasel language at the end of their decision to the effect that they were keeping an eye on things and that it might be the case that sometime in the future, should conditions change, they would re-visit the issue.
The Danger of the Decision
Using our reason, we can see that this decision will further weaken our already shaky financial system. Here's why.
The decision weakens the effectiveness of using CDS to hedge against loss. If I am trying to hedge my position by using a CDS, but now see that the CDS I buy might not pay off, I will either not take the position (e.g., buy a country's bond) or I will not buy CDS (because I don't think they will pay off when needed).
If I don't buy the bonds, then the country selling the bonds can't get the money they need, which would mean they can't meet some obligation they have (which is why they would be selling the bond in the first place), which weakens their financial position. If I don't hedge my position by buying CDS and the country won't pay me my interest or principal as agreed, that weakens my financial position.
Previously, the ISDA already ruled previously that a plan to have Greek bond holders take a 30% haircut wasn't a default. That plan obviously failed; that's why the new plan of a 50%+ haircut was needed. When the ISDA said the 30% haircut wasn't a default, shortly thereafter MF Global collapsed.
In a system that depends on derivatives, weakening the effectiveness of derivatives weakens the system.
This decision will further weaken our system. Based on previous experience of the ISDA saying that default wasn't a default, it may also cause another MF Global-type collapse
Background
The Internation Swaps and Derivatives Association is a global trade association the sets the rules for OTC or Over the Counter derivative transactions. CDS sold by banks as insurance against default by Greek bonds are OTC derivative transactions. The Greek government cannot meet the interest payments on the bonds they've issued. European Union officials recently brokered an agreement that stipulated that holders of those Greek bonds would agree to take a 50%+ haircut on the principal value of the Greek bonds they are holding. In addition, the Greek bonds holders will swap their existing bonds for new bonds that would effectively reduce the amount of interest the Greek government would pay.
Last Week's Action by the ISDA
The ISDA was called on to rule whether this agreement - where the principal value of the bonds would be reduced and the interest payments restated - was in fact a default. They said it was not a default.
(If someone owed you $1,000 and agreed to pay you back in 10 installments of $100 over 10 week and then told you that they would only pay you $500 in 10 installments of $50 over 10 weeks, you could reasonable tell them that they were defaulting on their obligation.)
The members of the committee that decided this was not a default were banks. Some of these banks (perhaps all of them) had issued CDS against Greek bonds. They would have lost billions if they had to pay up. So they decided there was no default; therefore they don't have to pay up.
In order to try to deflect criticism for an obvious conflict of interest, the put in weasel language at the end of their decision to the effect that they were keeping an eye on things and that it might be the case that sometime in the future, should conditions change, they would re-visit the issue.
The Danger of the Decision
Using our reason, we can see that this decision will further weaken our already shaky financial system. Here's why.
The decision weakens the effectiveness of using CDS to hedge against loss. If I am trying to hedge my position by using a CDS, but now see that the CDS I buy might not pay off, I will either not take the position (e.g., buy a country's bond) or I will not buy CDS (because I don't think they will pay off when needed).
If I don't buy the bonds, then the country selling the bonds can't get the money they need, which would mean they can't meet some obligation they have (which is why they would be selling the bond in the first place), which weakens their financial position. If I don't hedge my position by buying CDS and the country won't pay me my interest or principal as agreed, that weakens my financial position.
Previously, the ISDA already ruled previously that a plan to have Greek bond holders take a 30% haircut wasn't a default. That plan obviously failed; that's why the new plan of a 50%+ haircut was needed. When the ISDA said the 30% haircut wasn't a default, shortly thereafter MF Global collapsed.
In a system that depends on derivatives, weakening the effectiveness of derivatives weakens the system.
This decision will further weaken our system. Based on previous experience of the ISDA saying that default wasn't a default, it may also cause another MF Global-type collapse
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