Imagine you bought a house and, to insure it, you had to purchase coverage from the homebuilder.
Then imagine a fire nearly destroyed the house, but your ability to collect the insurance depended on a committee of anonymous homebuilders meeting in secret to vote on whether to write you a check. If denied, the panel wouldn’t have to provide an explanation, you wouldn’t be allowed to review the minutes of closed-door discussions and you’d have no right to appeal.
Not a great system. But not dissimilar to the one that governs the world of credit-default swaps, the contracts that insure sovereign- and corporate-debt investors against default. Panels made up of representatives from large banks, hedge funds, investment firms and other interested parties, formed by the International Swaps and Derivatives Association, decide whether payouts will be made to investors.
With the Greek crisis, the group has been busy. It already ruled March 1 that Greece’s debt restructuring so far wasn’t a “credit event,” meaning it didn’t trigger payments on credit-default swaps. It may have been the correct decision. But no outsiders participated in that meeting. No transcript was made public. And when the determinations committee, as it’s called, issued a decision, a terse 300-word explanation was provided. As for CDS buyers, there was no opportunity for an appeal.
Although the names of the firms on this committee are known, including JPMorgan Chase & Co., Goldman Sachs Group Inc., Morgan Stanley and Pacific Investment Management Co., the individual decision makers are not. What’s more, the financial stake that the firms have in Greek debt is not disclosed, although that information is sometimes available in regulatory filings.
True, only a relatively small amount of money -- about $3.2 billion after netting all parties’ exposures -- is in play. But there’s a larger issue here: the integrity of the ISDA process, of which Greece offers the first of several potential tests. If Ireland, Italy, Portugal, Spain or any other troubled European Union country sought to restructure its debts like Greece, the heretofore obscure ISDA could become a household name.
The next test could come as early as Thursday evening, when private bondholders must decide whether they are willing to swap existing Greek debt for new bonds, in the process accepting losses on more than half the face value of their current bonds. If the Greek government doesn’t get 75 percent acceptance, it will invoke a legal clause to force all private creditors to accept the exchange. If that happens, then ISDA may have no choice but to declare the restructuring coercive, not voluntary, and trigger the CDS payouts.
ISDA defends its procedures, arguing that its panelists must have market expertise. Five of the 15 members on the Greek CDS committee are from the buy side, meaning they represent investors such as mutual funds. A supermajority, 12 of the 15, is required for a credit event decision, meaning that the 10 sell-side panelists -- representing mostly major banks -- can’t ram through a decision that benefits only them. Furthermore, ISDA says, a CDS is a binding, legal contract to which all market participants have agreed. Little is left to the imagination: Definitions of credit events and other legal terms are 100 pages long.
The CDS market, thanks to ISDA and pressure from the New York Fed, already operates far more smoothly than it did just a few years ago. Until 2009, the question of whether a credit event had occurred was duked out between each CDS buyer and seller. A major default could have brought financial disaster. Still, the CDS market would benefit further if ISDA deliberations were made public -- minutes could even be released a week or two after the fact, the way the Federal Reserve publishes its monetary policy deliberations.
More to the point, monumental decisions involving billions of dollars ideally should be made by an outside, independent group. ISDA already has such groups in the wings, but it uses them only in case a determinations committee can’t get agreement from a supermajority and needs to hand off the matter to a neutral panel.
In any market, secrecy begets fear. The credit markets must be supremely confident that judgments about credit events are made in good faith. And investors must believe they are being dealt with fairly. If they think default insurance no longer protects them, they might simply avoid owning the bonds of Ireland, Italy, Portugal and Spain, undermining the CDS market and endangering those countries’ ability to survive the debt crisis.
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