CDS spreads again

Simon Johnson is alarmed about the very striking recent spike in Irish CDS spreads.

22 replies on “CDS spreads again”

I spend a bit of time over the last couple days talking to some senior advisors and others. They were stunned at how fast these moved on friday. It was well trailed that the recap would be minimal – the consequence of this plus the lunatic actions of ILP and Anglo is that it is, imho, now more rather than less likely that nationalisation will happen. Combine this with Greg’s misgivings on the credit allocation issue under FF, and its no wonder that the CDS and bond spreads widened.
The level may be wrong but the trend is right….

If the CDS are surging for ireland are they pricing the risk of the banks or the country? because the state still have infinite revenue raising ability against the nation so why wouldn’t the risk just be priced into the institutions rather than the country?

if there was a default i have a feeling that a few CDS holders would get burned in the process because the one thing that isn’t being tested is counterparty ability to pay/counterparty risk. obviously it would be better if we never found out what might happen.

karl. Good point re counterparty. However, the risk is on the state not the banks as we guarantee them. The fact that the cds market prices the state higher than them indicates they see us picking up the tab as they are bust.

@Brian but doesn’t that cast doubt over the states revenue raising ability more than anything? If that is in doubt it is worse than the bank situation no? because with banks getting ratings lowered it puts our national AAA in doubt [if indeed the CDS spread is falling on to the tax payer] and treasury rules internationally will kick in and force money out of the banks/country if we are downgraded. Is the fear around the country or the banks?

Go long in Irish CDS contracts. Go short in Irish government bonds. Newspapers and bloggers comment on the rising CDS spreads resulting from the former trade and Irish government bond prices fall. Your short position is profitable.

Nice money if you can get it.

While the Irish fiscal and economic situation is severe, Ireland does not require any external assistance. It has a low public debt, an asset-rich sovereign wealth fund and plenty of capacity to raise taxes and cut public spending after a decade of rapid fiscal expansion.

Moreover, it is quite unhelpful for outsiders to call for intervention, since it adds fuel to ill-founded concerns about sustainability.

The CDS dynamics are similar to those of a speculative attack on a currency. While speculative attacks can be self-fulfilling if the fundamentals are weak enough, plenty of speculative attacks peter out and this is the most likely scenario in the Irish case also.

I’d like to strongly endorse Philip’s comment about the unhelpful nature of Johnson’s comments. To my mind, this is an example of blogging at its worst. In his short post, Johnson suggests the need for outside intervention but doesn’t explain why this is required. What exactly is he proposing the EU or IMF should do about Ireland right now? The invocation of Iceland is inflammatory and inaccurate. Iceland was not in the Eurosystem and its financial institutions had massive foreign-currency denominated liabilities. And, predictably given Johnson’s stature as a former IMF chief economist, this stuff ends up on the front of the Sunday newspapers. Not helpful.

If the markets are now fixated on tail risks or whatever you call them now, while they seem to have happily ignored their existence for the past few years, then is that an argument for getting all the bad news out there as soon as possible as regards the banks and so on, on the basis that it is probably not as bad as the markets’ worse case scenarios?

Err – Folks , am I the only one that thinks ignoring the views of the external world is a poor response? Its not simply credible to say that outsiders shouldnt comment or that their comments , to us, look unhelpful.
This, im afraid, is how we are seen externally. We can ignore it, or we can act on it. And also, since when did someones “outsider” or “insider” (how defined btw?) determine how and when they should comment on issues? Should we shaddup on say the macro finances of Bolivia, or the financail markets in the ukraine? Should we look at portugal and say “well, maybe I should ignore the numbers, after all I am not portugese, and let someone from Lisbon take the lead”. Im semi- stunned at the reactions here : ignoring how the world sees us is 100% the wrong reaction now.

Brian is right that the ‘outsider/insider’ distinction is superfluous – that element in my comment is badly judged. I would have the same opinion of a domestic commentator that called for external intervention.

While the markets are twitchy at the moment, I doubt if they are so ill-informed to be swayed by such comments — even from a former IMF chief economist. Creditors only care about getting their money back. Good contingency planning for in extremis sources of funding should make them more confident not less.

While we should certainly heed the warning signals in the recent CDS spreads, we are entitled to regard Johnson’s comments are unhelpful. His comments contain no sense of balance or recognition of the efforts which Ireland is making to manage this problem.The media cloaks him in the mantle of “former IMF Chief Economist” which gives these comments a quasi-official air. As far as I can tell, Johnson was “Economic Counsellor” at the IMF for a year and left as part of a large-scale rationalisation. Even when he was with the IMF, I strongly doubt he could put anything on the agenda.

The Sunday Times picked up on this story and gives it a singularly mischievous headline – “Ireland ‘could default on debt’ “. Add this to the substantial catalogue of British media mischief on our economic woes.

The Guardian are at it as well – you shouldnt ignore outsiders Brian – that goes without saying but do you not feel even an inkling of annoyance when an article like this is written? An awful lot is at stake and while criticising the Irish financial system is absolutely legitimate, good newspapers should not just start parroting rumours about imminent defaults without asking who is spreading them and why they are spreading them and whether there is a legitimate basis for them other than they might become self-fulfilling.

In times like these people will naturally seeks to “see who is next” with morbid fascination and perhaps in some instances with a pecuniary interest as well.

So how about posting a presentation for us “outsiders” that shows where Ireland really is?

Yes, whinge and whine about Simon Johnson if you have to, but please do reply with at least some facts. I for one would be curious to know why Ireland’s ratio of bank liabilities to GDP at 900% should be of no concern. Are Irish banks that safe? Is there no currency mismatch in their assets and liabilities? Have non performing loans stayed level?

In relation to the insider/outsider point, I had already corrected my original comment that such a distinction is not appropriate at all – I would have the same opinion of a call by a domestic commentator for external intervention.

I am all in favour of vigorous intellectual competition in relation to the state of the Irish economy. The concern is that there are plenty of ‘noise’ traders in markets, in addition to fully-informed rational traders and the “limits to arbitrage” problem means that there is no guarantee that the latter group will dominate.

This problem is especially acute for small economies since fixed costs in ‘information acquisition and analysis’ mean that there is less incentive for traders to become fully informed, increasing the sensitivity of traders to ‘rumours’ (or, more generally, blog postings by very influential former Chief Economists of the IMF). This phenomenon is well described by Calvo and Mendoza, “Rational Contagion and the Globalization of Securities Markets”, Journal of International Economics, 2000.

There is certainly a significant set of international traders who are excellent analysts of the Irish economy and, on net, I think the role of international investors (including hedge funds etc) has been very helpful in signalling problems in the Irish economy. However, it is also possible that, at some point, the set of less-informed traders may become more influential, especially in very thin, non-transparent illiquid markets such as the CDS market for Irish sovereign debt.

As is well known, there are many models in which ‘multiple equilibria’ are possible in asset pricing (so long as the macro fundamentals are sufficiently weak to give some weighting to ‘collapse’ scenarios). Accordingly, calls by eminent economists for external intervention can influence markets for the reasons given above.

The post suggests that the audience for this kind of debate is the set of policymakers. If this were the only audience, I am all in favour of a wide-ranging debate that considers all possible scenarios. However, my concern is that the larger audience consists of the global pool of investors and opinion makers that relies on influential commentators such as Simon Johnson to learn about the Irish economy. It is in this context that I believe that the original posting was not helpful.

@Liam : Liam, my sense of annoyance is directed at the domestic front. In the Guardian piece can you direct me to any part that is wrong? Definitionally as CDS spreads the percieved risk of default rises. Now, CDS levels are like any other price level and contain a bunch of rational and other elements. But the trend of these plus the trend of the bond market do indicate growing international loss of credibility. Not all bond traders are chinless europhobic ex-Guards officers in london….
Im with Kevin – clear it out, now , totally, and let the dust settle. Remember, markets are fine with risks but not with uncertainty.

Pavel: I think your 900% is coming from table C3 in the Central Bank monthly return. This is the ‘Aggregate’ balance sheet of the banks, and includes double-counting. Table C1 is the ‘Consolidated’ balance sheet, and does not. It shows total liabilities in december last about 250% of GDP, and net foreign liabilities under 50%.

Colm: Yes Sir! You’re right. Thank you.

I guess by quickly looking up a data table over morning coffee without properly checking what I was looking at I may have inadvertently proved my own point: facts and data for “outsiders”, please!

In response to Pawel, I think 250% is no minor issue. Many emerging markets collapsed with far far less liabilities! Where does the Irish government get the funds to cover the large losses that could be realized on the 250% of GDP? When going from credit boom to credit bust, it is not politically easy to wrestle new tax revenues to finance past debt from angry citizens. Ireland, as the first nation in this crisis to “guarantee” all liabilities of major commerical banks may not be able to afford it. Most of the rest of Europe didn’t act with such poorly thought out haste. Perhaps this is why markets are selling down Irish bonds? I think so… Good luck -the world is out of Ireland’s hands – it is time for Ireland’s politicians and respected economists to debate credible policies. Where is the fiscal program that can prove to Irish bond holders they will repay if the world recession is extremely deep? Where is the plan to recap all banks that is consistent with any fiscal program? Please prove the political sustainability of all this as M. Trichet keeps ECB rates high and there is no common fiscal policy for the EU? Us outsiders have seen many collapses, and yes, Ireland seems right behind Iceland to date. Ireland is also, regardless of what anyone may wish, in a basket with Greece, Spain Italy and Portugal. All these countries appear to have far more liabilities (including pensions and healthcare) than they can truly afford, and each needs a new credible fiscal framework backed by political will to survive. This will surely involve a deep recession. If any of those nations fail, sensible investors will naturally sell their Irish bonds just in case…Ireland needs economists and policy makers who have the forsesight to see the real potential risk of collapse and respond to it with policies. This is the reality of being at the end of a credit boom, in the eurozone, and not far from Iceland. Good luck!

There’s more from Simon Johnson picking up on Peer Steinbrueck’s remarks:

Simon stresses the need for the Irish Government “to address the underlying fundamental questions, and show everyone – clearly and persuasively – that Ireland is fiscally sound even with the contingent liabilities it has take on through guaranteeing bank liabilities.”

I think we all agree with that.

I wouldn’t attach too much importance to CDS. The market is small, illiquid, and often driven by technical considerations. Bond yield spreads and money market developments are far more important, in appraising risk.

For what it is worth, Irish 5-year CDS came in from around 380bp to some 320bp over the past few days. Risk appetite has tended to pick up, as governments go into overdrive in propping up financial markets (notably Obama’s budget, etc. ). The move had nothing to with Ireland.

There was talk during the week that sovereigns have quite a few tricks up their sleeves. This helped spreads recover, leading to a bout of profit taking on risk aversion type strategies. Effectively we doubt that CDS give protection in scenarios that many investors have in mind for sovereigns. We will not get, we believe, to a situation where there will be a trigger event calling sovereign CDS (and the contracts could be seen as clear as mud in some scenarios, we fear).

So we are at ease with long term value in selling sovereign CDS – that is, over the next three years – especially against corporates. It is overly simple to see the eurozone’s future as a black and white affair. It is not a case of simply being “in” or “out”. There are many grey alternatives. CDS may well give no protection in grey scenarios. That however gets us into economic/legal quagmire that we cannot write about in much depth. We have seen richening of CDS in a generalised flight to quality, of the kind seen over the past few months. But many investors were not looking in much detail at the bottom line, if the crunch were ever to materialise. Sovereigns however will remain sovereign, with exceptional powers to appropriate and work around the financial icebergs that are ahead of us.

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