Will CDS Survive the European Debt Crisis?

Governments and large issuers hate them, regulators wrestle with them and the general public do not have a clue of what they are, but Credit Default Swaps are the cleanest way to hedge credit risk.  They also promote liquidity (ok, and sometimes volatility) into the bond markets as bond holders can buy CDS protection instead of selling bonds in the open market.  But as Greece and other issuers start to test the waters with voluntary bond swaps, where large investors take a significant haircut on the principle value of the bonds in order to stem a default, CDS holders are crying foul.

In a recognized credit default (i.e. inability to pay the interest payment), a CDS holder can deliver the defaulted bonds and receive the principal value of the delivered bonds, leaving the CDS seller with the loss when it goes to sell the delivered bonds, usually cents on the dollar.  Legally, there doesn’t seem to be grounds for triggering a default if bond holders voluntarily agree to take a haircut on the bond.

Certainly hedge funds who have sold short the bonds via the CDS are fuming as they were hoping to have a huge pay day, which certainly would have happened if it were not for the “voluntary” haircut pressure on the banks from the governments.  Longer term investors who are paying for CDS protection, which for European sovereign debt is currently very expensive, may not only suffer the lower price on the bond swap, but also may have paid for insurance that probably would have made them whole in the event of a default.  As an analogy, if home owners insurance only paid out when robbers stole all of your valuables but not half, you probably wouldn’t be willing to pay for that kind of insurance.

We have known for over six months about the dire situation in Greece and the pending domino effect that would be spurred across Europe.  And despite the changes in governments in Greece and Italy, which should have bought some reprieve, we have seen a nasty sell off in most of the Euro debt in the past week.  Clearly, one of the drivers has been that market participants must be seeing that CDS will not protect their credit risk as once thought, so they have no choice but to reduce risk now by selling down their sovereign credit risk with few cash buyers brave enough to buy as they too may see the writing on the wall on the strength of CDS protection.  Could this be the catalyst that will kill the CDS product?  If it is, then we will have lot more to worry about than the health of the CDS market.