Morgan Stanley publishes primer on sovereign CDS credit events

Against a backdrop of continued investor uncertainty around the potential for sovereigns – in particular Greece – to trigger a restructuring credit event, Morgan Stanley has today published a credit event and auction primer for sovereign credit default swaps. In it, analysts note that scenarios where a sovereign stops servicing debts or amends certain terms to impose ‘restructuring’ should provide a clear trigger to CDS. Scenarios involving ‘exchanges’, however, depend heavily on the exact manner in which they are conducted and are a potential concern for buyers of protection.

‘Legally binding on all holders’ is the key to whether restructuring triggers CDS, says Morgan Stanley. This would mean that the restructuring is mandatory for all holders of an obligation, or all holders of an obligation agree to the restructuring, or that the consent of only a specified majority of holders is required to approve the restructuring on behalf of all of the holders.

Morgan Stanley view it as irrelevant whether the amendments are voluntary or not, as the required element is ‘binding on all holders’ not ‘enforcement’. Any threats (verbal or economic) would not legally bind all holders and would therefore not trigger CDS, say analysts. For investors who did not accept unfavourable terms, if such threats materialise at a later date and the obligations of the issuer under the bond documents are not honoured (say non-payment of coupons), then investors could potentially trigger a ‘failure to pay’ credit event. 

The general precedent is that a restructuring credit event is likely if the terms of an existing obligation are amended to cause one of the restructuring outcomes outlined. An exchange of one obligation for another is much less likely to trigger, even though the economic outcome might be the same. Morgan Stanley allows there is a possibility that, if an exchange was engineered in a way that legally binds all holders (e.g. by law), and, after the exchange, the holders are left with obligations with less favourable terms, then the Isda determinations committee might rule in favour of a restructuring credit event based on the merits of the individual case. However, the outcome is far from certain and there is no precedent for such an event at present.

For example, Anglo Irish’s restructuring credit event was triggered by the insertion of a call option below par – although this was obviously designed to persuade potential hold-outs to accept the exchange. Anglo Irish offered an exchange of existing bonds into new bonds with reduced face value (20%), with every investor accepting the exchange in effect voting for insertion of an issuer call option at close to zero into the existing bonds (which were not exchanged). Given that the required majority of holders accepted, the terms of the bonds were amended to insert the call option. The call option was binding on all holders.

Elsewhere in the primer, Morgan Stanley examines various other aspects relevant to the sovereign CDS predicament, such as changes of law, collective action clauses, introduction of senior debt, different kinds of qualifying deliverable obligation, as well as the process for determining a sovereign credit event and the mechanics of auction settlement.