Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan

I am pleased that Dan Donovan (a highly-experienced trader in the financial markets) has taken the time to write an explanatory note on some of the most important features of the sovereign CDS market. See his contribution below.
From Dan Donovan:

As the current malaise in the credit markets unfolds one of the rapidly emerging issues has been the markets concern about various sovereign solvency issues, most particularly with regard to the ability or otherwise of countries to be able to pay for the varying forms of bank guarantee’s they have proffered.

Most agents seeking to express views that sovereigns would be unable to meet their commitments and or that the cost of doing so will escalate have been doing so via the Credit Default Swap market; buying “insurance” against the default of the named sovereign. It is note worthy how quickly and dramatically the cost of this insurance has escalated.. Ireland as can be seen below (ex Iceland) has borne the brunt of this position taking.

5y                  10y
Port     134/144       130/150
Ital      177/187       172/182
Gree    260/290       255/285
Spa     148/158       145/160
Irel      260/300       240/290
UK      140/150       137/147
Denk    109/119       108/120
Swe      110/125       115/130
Aust      145/155       145/145
Ger           56/66            56/66
Fran          63/73             64/74
Finl           55/65             57/67
Belg     115/135       113/133
Neth     105/125        105/120
Iceland  925/975          800/1000

Source JP Morgan.

It is tempting to dismiss such moves as merely a thin market overreacting to the current zeitgeist, for instance it now costs roughly 3 times as much to insure against a default of the UK government as it does to insure against the default of Cadburys! There are however some important issues to consider regarding the implications of such moves.

Price Setting: Many participants in the market are able to switch between writing CDS insurance and buying Government bonds. As such the CDS market which is more active than the underlying market can have the effect of defining the cost of borrowing for sovereigns despite the fact that there is very little in the way of transparency regarding who the agents in this market are and what volumes have been traded. Governments could be forced by virtue of this market to pay unnecessarily high (perhaps punitively high) borrowing costs.

Agency Issues:  The existence of the Sovereign CDS market may change, considerably, the motivation of traditional suppliers of credit extension to sovereigns.

Whilst the CDS market is a zero sum game, it is however conceivable that certain groups can accumulate considerable positions in the CDS (buying insurance) of a given Sovereign without holding any underlying positions in the securities referenced by such a CDS. It would then be optimal for such agents to fail to support the issuance programmes of the country in question. The reason being that this will benefit the CDS they own via the spread moving wider or in the extreme technical default of the Sovereign triggering the CDS contract. Under normal circumstances this issue would be so remote as to be irrelevant, but these are far from normal times and as such these issues need consideration.

Possible Solutions: It is certainly arguable that CDS contracts have been far from a force for good in these times and have done more damage than good and should be outlawed. It would be difficult to “put the Genie back in the bottle” however and as is the case in banning short selling may have severe unintended consequences. One simple strategy would be to enforce disclosure of all agents Sovereign CDS positions. Such transparency could be delivered in a very short time frame and would enable Issuers and the market in general to understand and interpret the actions of the varying market constituents more clearly.

5 thoughts on “Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan”

  1. That Euro Intelligence piece is severly flawed. It apportions blame in all the wrong places. It is alaso entirely misleading to refer to CDS and CDOs as though the two things are linked in any other way than the fact they are both derivatives. You may as well through interest rate swapos in there to further confuse the issue.

    One of the key problems with CDS contracts was that little to no collateral was required to be held against the probablility of payout because “historical” models created by ratings agencies showed that the likelihood of default was minimal. This allowed some parties (AIG and German Landesbanks for example) to sell enormous notional amounts of CDS in order to collect a positive carry without posting very much collateral. It is the utter failure of the risk managment staff at every institution that owns substantial notional amounts of CDS that should be blamed for the mess that they are in.

    Creating a central clearinghouse and requiring a reasonable amount of collateral to be posted upon the writing of a CDS contract would go a very long way to reducing the volatility of the market and encouraging a far more reasonable approach to the creation of new contracts.

    However it is wrong to suggest that CDS contracts add nothing to the system. In fact they help to facillitate credit price discovery by adding another tool that enhance the liquidity required for true discovery. They also help to offset risk – not just from the immediate underlying instruments but also from other positions in the credit or equities markets.

    Finally – it is flat out expropriation to cancel these contracts. They are binding legal agreements between two consenting parties. To arbitrarily cancel them is to steal the potential benefit from either party and to fundamentally undermine the right to contract – which just happens to be a key tenet in capitalism of all kinds.

  2. Issues in The Sovereign Credit Default Swap (CDS) Market: Guest contribution by Dan Donovan was interesting. You seem very knowledgeable in country insurance agents.

  3. In response to the question: what is the probability of default implied by these prices.

    The CDS is the extra per annum yield for taking on the payoff of default, restoring the CDS insured purchaser to full recovery value.

    The expected cost of taking on this risk is probability of default x loss given default. Suppose that the loss given default is 50% (a pretty severe default where the Irish government only pays 50 cents per Euro on its defaulted bonds) and setting expected cost = extra yield gives

    prob default x .5 = extra yield

    Using .0265 (mid point of Irish ten year yields) gives annual default risk of .053 and cumulative probabity of default over ten years time of 1 – (1-.056)^10 = .4199. So if you beleive this risk-neutral probability the financial markets are saying that there is a 42% chance that the Irish government will default some time during the next ten years! Not a vote of confidence in the Irish government or economy.

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