2012 Outlook

The year 2011 has been marked with extreme volatility, much to do indecisive politicians that have not only shown a lack of decision making and slow response to changing environments, but that have actively worked their way towards the wrong direction and into a corner. As such, when I received the following quote from an acquaintance, I could do nothing but concur.

As Year end draws nearer, the worry is the main positive for 2011 is it's looking likely to be a whole lot better than 2012...

There is nothing that would indicate the volatility to decrease in 2012. What has changed, however, is the psychology of it all. It is amazing what people, and then in particular market participants, can get used to. An equity index move of 3-5 per cent points is now nearly to consider normal, and at least don't prompt too much attention. The investors are also a different breed, and trying to learn to take advantage of the volatility to increase earnings, and act counter-cyclically to take advantages of dips in the market.

For the Fixed Income space, the phrases regulatory risk, execution risk and event risk has truly been experienced, and players are adapting to expect to wait for windows for proper transactions depending on the surroundings.

All of this is likely to continue, and the world is bracing for outcome of a break-up of the European monetary union. This coming week the International Swaps and Derivatives Association will hold a webcast with its members next week to discuss what would happen to euro-denominated derivatives contracts in the event of one or more countries leaving the euro zone.

Personally I'm not expecting a full-fledged break-up of the union within 2012 where the Euro completely cease to exist, resulting in a dependence on Lex Monetae for interpretations of contracts, but I do consider it likely to have one or several countries seceding the euro-zone and getting a New National Currency (NNC), which can result in interesting contractual effects and monetary flow control (prohibition of exporting hard cash from a country can result in a foreign governed contract not being enforceable still)

If nothing else 2012 looks to become a very interesting year - but not a year for the weak minded.

Are the politicians and rating agencies making a mockery of CDS market?

A few interesting stories popped up on Dow Jones Newswire today, again bringing up some questions regarding the credit triggers for the CDS (Credit Default Swap) market. A snippet of the story is quoted (highlighted by myself):

Standard & Poor's Friday said in a report that for issuers rated at Greece's level, single-B, a "voluntary" debt exchange would likely be default if creditors received securities with terms less favorable than are available in the secondary market. With 10-year Greek debt yielding 15% in the secondary market and two-year debt yielding over 20%, that is almost certain to be the case under the exchange process planned by euro-zone governments.

At the same time EU politicians are stating that

* DJ Deal Will Avoid Greek Credit Event But Not Necessarily Ratings Downgrade – Officials

Or looking more closely at the article:

“The ECB has opposed more coercive measures aimed at getting Greece's private-creditors to continue providing financing for the country starting in 2012. But the debt-exchange process envisioned by the governments won't rewrite existing bond contracts or trigger a credit event, the officials said, partly easing the ECB's concerns that private-creditors would be forced to contribute financing.”

CDSes are normally written under the ISDA Master Agreement (International Swaps and Derivatives Association) , in which a credit event follows in the situations

  • reference entity bankruptcy
  • failure to pay,
  • obligation acceleration,
  • repudiation (When one party refuses to honor its terms in a loan contract. )
  • moratorium. 

If we make a note of the S&P statement, voluntary is enclosed in quotes. I suspect this is based on the amount of incentives involved for the current bondholders to participate on a “voluntary” basis. One example of such an incentive would be

The governments are also looking to the European Central Bank to encourage the exchange offer by accepting the new Greek bonds as collateral for lending while refusing to accept the old ones, the officials said.

The argument would then be, if enough (too many) incentives are given to participate on a voluntary basis, it would be a de-facto obligation acceleration and as such constitute a credit event.

Now that prompts the following question from my side. If something would qualify as a credit event for a B rated issuer (and keep in mind the debt has already been down-notched substantially), but could be avoided if the rating agencies further downgrade the rating on a post-hoc basis, as can be inferred from the politicians suggestion. Are they really making a mockery of the CDS market? If this is the situation a credit event would “never” be a reality for sovereign bonds.

Can we really have a situation where that would not happen if the rating agencies would further downgrade the issuer after the fact?