Greek Debt Fix a Bad Deal for Holders of Credit Default Swaps

Holders of credit default swaps on Greek bonds may be out of luck, thanks to the European Union’s plan to resolve the euro region’s sovereign debt crisis. According to a report from Bloomberg News, because the plan is considered voluntary, firms that sold a net total of $3.7 billion of credit protection on Greece won’t be required to pay buyers of the credit default swaps.

According to Bloomberg, credit default swaps are essentially insurance contracts on bonds; in the event of a default on the bond, the seller of the swap promises to pay the buyer the bond’s value. The European Union’s solution to the sovereign debt crisis requires that investors in Greek bonds write down, or take a loss, of 50 percent of their holdings. The alternative is a full default on Greek debt.

Though, as Bloomberg notes, the deal involves a lot of “arm twisting,” the architects of the fix say they “invite Greece, private investors and all parties concerned to develop a voluntary bond exchange,” into new securities. Banks and the International Swaps and Derivatives Association have indicated they would consider the restructuring voluntary, because all bondholders aren’t technically bound by the deal. As such, the restructuring wouldn’t be considered a “credit event” – a default – that would trigger payments on swaps.

This aspect of the deal could threaten the viability of the whole credit default swap market, according to Bloomberg.

“It punishes the banks that were well-hedged and managed, and I think it’s just starting to sink in as to what this might mean,” Peter Tchir, the founder of hedge fund TF Market Advisors in New York, told Bloomberg “Bank hedging desks are definitely now trying to re-evaluate” their use of default swaps, he added.

The predicament has raised the specter of legal action that could put the entire Greek debt deal in jeopardy. According to a report from “This is Money,” a financial reporting website out of the United Kingdom, hedge funds and other investors may go to court to challenge the claim of eurozone leaders that Greece has not defaulted on its debt. Lawyers quoted by the article said such a legal challenge would likely come from smaller wealthy traders and investors could have huge sums at stake,” rather than banks holding swaps on Greek debt.

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