601bre44380_ch23_597-617.indd 601 09/30/15 12:08 PM
◗ FIGURE 23.3 Credit default swaps insure the holders of corporate bonds against default. This figure shows
the cost of default swaps on the 8-year senior debt of three companies.
Source: Datastream1/1/20065/1/20069/1/20061/1/20075/1/20079/1/20071/1/20085/1/20089/1/20081/1/20095/1/20099/1/20091/1/20105/1/20109/1/20100100200300400500600Basis pointsDow ChemicalPfizerBank of America● ● ● ● ●FINANCE IN PRACTICE
❱ At the start of 2012, holders of $3.2 billion of Greek
government debt had bought credit default swaps that
insured them against default. Governments in Europe
worried that if the insurance were triggered, the banks that
had sold it would suffer significant losses. Could Greece
somehow avoid paying its debts without defaulting?
The governments’ solution was to ask (or strong-arm)
private bond holders to voluntarily exchange their exist-
ing bonds for a package of new securities worth about
30% of the value of their existing bonds. The decision
as to whether this would trigger payment on the default
swaps was the responsibility of the International Swaps
and Derivatives Association (ISDA). In such cases, the
ISDA arranges for a Determinations Committee to decide
whether there has been a “credit event.” Once the commit-
tee acknowledges that a credit event has occurred, an auc-
tion is conducted to determine the value of the defaulted
bonds; owners of default swaps are paid the difference
between this auction value and the face value of the bonds.
The ISDA’s Determinations Committee has 15 mem-
bers. Ten are dealers and five represent investors. The
dealer representatives must be participating bidders in
the auctions determining payouts, and the ones who
are chosen are likely to have the biggest positions. The
investor members must have at least $1 billion of assets
under management and $1 billion of CDS exposure.
Thus the people on the Determinations Committee are
not disinterested parties, and this has the potential to
cause problems.
The Determinations Committee initially ruled that
if Greece’s proposed bond exchange was indeed volun-
tary, then it could not be regarded as a default. How-
ever, this decision was rapidly overtaken by events.
Greece announced that it had persuaded a majority of its
private-sector creditors to accept its proposal and that it
would activate “collective action clauses” that had been
retrospectively inserted into the bonds’ terms and condi-
tions. These clauses would coerce the remaining reluc-
tant bondholders to accept the deal and swap their old
bonds for new. At that point in March 2012, the Deter-
minations Committee formally ruled that Greece was in
default and that payments were due on the default swaps.What Exactly Is a Default?