Thursday, October 27, 2011

RIP DM Sovereign CDS (2006-2011)

Like many derivatives products dreamed up by Wall Street's financial innovators, the Developed Market (DM) Sovereign Credit Default Swap (CDS) market was born out of the desire to transfer risk off the books of banks to investors suited to managing those risks. Following the successful establishment and effectiveness of risk transfer in the corporate CDS market, the onset of the Asian Financial Crisis spurred growth in trading in Credit Default Swaps on Emerging Market countries' debt. However, legal documentation issues relating to the 1998 Russian bond default hinted at the structural problems embedded in the contracts, subsequently confirmed when the economically coercive 2001 Argentinean so-called "Mega-Swap" did not trigger CDS. Indeed, even though Argentina eventually repudiated its debt unilaterally, many protection buyers' swaps had already expired by then, and trading volumes in EM CDS fell substantially, only really recovering post the 2003 overhaul of ISDA's rulebook.

It is then, perhaps, surprising that despite proven complications related to the terms under which EM Sovereign CDS would pay out that market participants extended the concept to cover Developed Market Sovereigns in 2006. Arguably, along with its siblings ABS CDS, made famous by Hedge Fund manager John Paulson's multi-billion dollar bet against the US Subprime market, trading in DM CDS took off as a way to hedge the risk of countries who had been forced to assume the liabilities of their banking systems coming under pressure themselves. But as with earlier EM-specific non-triggers, the Icelandic government's decision to put its banks into administration in November 2008 rather than default on its own debt, resulted in its CDS falling from as wide as 1400bps to current levels closer to 320bps. The LSE's Professor Willem Buiter, a former Bank of England MPC member, in early-2009 asked the question "Is London Reykjavik on Thames?", leading to CDS on the UK to spike to as high as 166bps, but this sparked many to point out that the UK's debt was denominated in Sterling, which the Bank of England could print an unlimited amount of. A month later, in March 2009 the Bank of England's decision to purchase £75bn in its Asset Purchase Programme seemed to support this view, despite a second widening of UK CDS in the run up to the 2010 General Election as investors worried about the UK government's commitment to its medium term solvency.

Nevertheless, the incoming PASOK-led Greek government revealed in November 2009 that the country had under-reported its deficits, triggering the onset of the Eurozone crisis, and Greek CDS began to widen, culminating in the April 2010 EU/IMF bailout of Greece, and a month later, in the face of contagion to other European government bond markets, the establishment of the European Financial Stability Facility (EFSF). An explosion in trading of DM CDS on Eurozone peripheral countries' debt ensued as hedge funds sought to speculate upon the likelihood of an eventual Greek default and banks sought to hedge their exposures to those countries built up over the preceding decade.

Inevitably, faced with the political cost of bailing out foreign countries, European politicians lashed out at the CDS market, blaming it for breeding panic and allowing speculators to "bet" against bond markets and the Euro. As seen in the 2008 Global Financial Crisis, banks under pressure, along with politicians, blamed short sellers and speculators for spreading rumours and exacerbating the situation, while speculators argued that the market was merely "the messenger", pointing to fundamental problems with balance sheets. As financial market pressures became ever more severe, European policymakers resorted to short selling bans and attempted to implement a ban on CDS trading. The debate continues to rage over whether the CDS market caused or exacerbated the Eurozone crisis, or whether the crisis was inevitable.

But what eventually killed the Developed Market Credit Default Swap market in the end, was the agreement with the Institute of International Finance (IIF), representing banks owning Greek bonds, to accept a 50% haircut on their holdings. The possibility that despite such a large haircut on Greece's debt, that CDS contracts would not trigger, led many investors and bank hedging desks to question the value of their CDS contracts. The repercussions soon spread, as those institutions that believed they had hedged their bond holdings, or bet upon a Greek default, rushed to sell their contracts before the price collapsed. Volumes soon collapsed as it became evident that developed market governments had the ability to force their banks into taking haircuts without rewarding what they view as speculators.

Developed Market CDS soon faded into history alongside Perpetual Floating Rate Notes, Libor-cubed Notes, Asset Backed Collateralised Debt Obligations, War Loans, Endowment Mortgages and other financial products that were found wanting.


But What do I Know? said...

Yeah, it looks like the bookie isn't going to pay off. Try and collect from him :>)

I saw on Bloomberg that the Greek government said it would support its banks by taking stakes in them. So the Greek government is going to take over its banks because they ran into trouble due to their ownership of Greek government debt which can't be repaid because the Greek government doesn't have the money!

Did I get that right?

Anonymous said...

Great post - maybe your best ever. Think I am going to sell some uk and chinese cds

Anonymous said...

Great post.

What if ISDA's rulebook includes additional triggers of:
1) A default or selective default rating by any 2 of the rating agencies
2) Any restructuring of more than 50% of the debt

abee crombie said...

sounds like someone is short CDS

not my game, but I agree with the points you make

but I doubt they go away totally, just like bankrupt companies stock still trading at $1, its one of those things that makes no sense but is still part of the game

Anonymous said...


Nemo Incognito said...

China CDS 200 --> 120ish last I checked since we posted on it. In the words of that modest fellow Kanye West:

so i live by two words
fuck you
pay me

Charles said...

Looks like a good time for exchanges to launch long dated government bond futures. It was the appropriate structure from day one. Just too transparent for banks...

Nemo Incognito said...

Charles - quite. Seriously overdue and given banks are providing bugger all liquidity in anything fixed income these days would take off quite well. Does anyone at CME read this blog?

Leftback said...

Nice. Sovereign CDS were always a bit like putting wheels on a snake. Not really necessary since you can simply short that nation's banks and sell the bonds.

So now that Ch. Eurobolleaux™ has been uncorked at a fabulous party in Bruxelles, a few questions for the assembled multitude:

1) Sell gold and silver? (we're already doing it)
2) Sell the yen?
3) EURUSD topping here?
4) ECRI say: "Where's my recession?"
5) US GDP 2.5%. Really?
6) Sell USTs/bunds, buy Portuguese debt? (LOL)
7) How many times will we watch this movie?
8) DMs over EMs into EoY?
9) Banker bonuses saved for 2011?
10) Recapitalization by diluting shareholders?

Anonymous said...

Question - if a bank takes a "voluntary" 50% haircut/forgiveness, isn's a CDS seller still owed the full coupon on 100% of principal, on time? So if you are a bank that owned greek debt on its books but bought CDS protection, aren't you screwed (must haircut 50% but still owe 100% on the CDS?)???

Anonymous said...

C says'

"8) DMs over EMs into EoY?"

So you still believe in Santa Claus and presmably then the Eurotwats are his elves? Well have I got a present for you ;)

Anonymous said...

Crazy question but seeing as it's a voluntary haircut of 50%, is there any chance that a renegade holder of this debt says no? ISDA has said that a "voluntary" haircut won't trigger CDS but they won't look at whether it should be considered a default until requested by one of their members.

Secret--Sauce said...

50% haircut and isda says no default. The master agreement says nothing at all.

What's Bloke to do? Whocouldanowd?

The Eurologist said...

Anon 3:59

In any place that matters (ie France and Germany) this is all a matter of national interest. No bank is going to go and seek recompense for a cds position. This is Europe.

Anyone, by the way, who ever seriously thought that this would have turned out materially different than it has, umm, deserves that heap of 1.38 bund futures.

Now back to the imminent recession...

Nic said...

Long Greek Govt debt has to a no brainer trade unless you are an insolvent European bank that requires your taxpayers financial support and therefore can be leaned on.
Yes Mr G-pap, I would like a 50% haircut. Not.

CV said...

Guys, you are missing the almost painful irony here.

The banks get rolled in at midnight and told they get a 50% haircut. The ISDA "decides" that this is voluntary (perhaps they got a phonecall from someone?) and CDS holders are screwed.

Ok, don't hate the player, hate the game. BUT, the beauty is of course that this new EFSF is going to do what? Well, issue CDS on Spanish and Italian debt of course.

This is beyond stupid. They have no clue about any of this in Bruxelles. Who is going to set up this Frankenstein of an EFSF ... the Squid?


Anonymous said...

Out of the ashes of the sovereign CDS, will we see the rise of the sovereign Credit Restructuring Swap? Out with the old, in with the new?

Anonymous said...

ISDA don't decide until after the event - so technically not known yet.

Look at the make-up of the ISDA Credit Determination Committee. Banks, with 1-2 large hedge funds / traditional asset managers on.

Lots of hedge funds, in light of this - have been pushing to change the composition - more HFs - which means, unlike banks - less likely to roll over and be told not to make it a credit event...

Anonymous said...

Errm aren't most hedge funds long GGB's and therefore it is in their interest that it is a "voluntary" haircut for the banks?
They don't have to take the haircut = massive win

Reeceloui said...

The Asian Financial Crisis spurred advance in market investment in Credit Default Swaps on Market countries' debt.It's also give different crisis for debt matter.


Reeceloui said...

The Asian Financial Crisis spurred growth in trading in Credit Default Swaps on Emerging Market countries' debt. the Market Credit Default market in the end, was the agreement with the Institute of International Finance.

debt consolidation