Say you bought insurance that was supposed to pay out if you got into a car accident. Then you got into a car accident. And a committee met and decided that, actually, you did not get into a car accident.
That's what almost happened with Greek debt.
Financial instruments called credit default swaps, or CDS, are like insurance policies for lenders. They pay out when borrowers default on their loans. But a few weeks back, the officials who decide such things said that there were not likely to be payouts on CDS on Greek bonds.
Here's why: CDS are only triggered by defaults that affect everybody. Until very recently, Greece said its debt restructuring plan would be voluntary. Bondholders were supposed to be able to decide whether or not they would participate.
Part of the whole idea of making it voluntary was to avoid triggering CDS, out of fear of rattling Europe's already rattled financial system. As you may recall, credit default swaps on mortgage-backed securities were one element of the house of cards that collapsed during the financial crisis, taking down AIG.
But the voluntary thing seemed dubious from the outset. Who would choose to take a loss on bonds?
And the idea that Greece might default on its sovereign bonds without triggering payouts on Greek CDS called into question the whole idea of buying CDS on sovereign bonds. Why pay for insurance if it never pays a claim?
In the end, though, Greece wound up forcing all bondholders to take a hit. And today, the committee that decides these things said, yes, Greece did default. And yes, CDS on Greek bonds will pay off. (Actually, the committee said a "restructuring credit event has occurred with respect to the Hellenic Republic." Which is the same thing.)
The CDS contracts will be settled by auction later this month, and it seems unlikely that the payouts will cause much trouble in the financial system.
The net payout on Greek CDS will likely be less than $3 billion, and most of that money has already been set aside by the companies who will have to make the payments, according to ISDA, the international body that oversees CDS.
For more, see this ISDA explainer (PDF).