I realise that at this stage it is probably academic over here, since the government seems to have decided to do whatever it is that it is going to do. But: what did people think of this suggestion, again (a) in general and (b) in the Irish context?
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.
In response to my earlier post on the nationalisation of Anglo Irish, Enrique DeLucas writes that “as Anglo was also an active syndicator with the other Irish commercial banks, any impact of large scale writedowns of their loan books would have a collosal impact on the remaining listed Irish banks”. In response to a further comment from Alan Ahearne he writes that “under IAS39, if a fire sale of Anglo’s assets gives specific evidence of a diminution in value of these assets, they must be marked down accordingly. As a result, this creates a requirement under Balse II to increase the capital adequacy reserve by this amount, thus impinging on the banks liquidity position and tier one capital ratios further”.
Do we know the extent of Anglo’s syndication with the other Irish banks, so that the importance of this effect could be assessed?
By the way, some info on who is advising the government: http://www.irishtimes.com/newspaper/finance/2009/0124/1232474679313.html
I had a long conversation last weekend with the MD of a Financial Services company to see how closely his private-sector non-economist perspective accorded with my own (which is probably the consensus among public-sector economists), that Anglo should have been allowed to collapse and the developers bankrupted if necessary. There was little difference in our perspectives!
He thought the idea ludicrous that Anglo-Irish could regain the trust necessary to get back to “business as usual”. Also, he tells me that a receiver will not necessarily dump all distressed assets onto the market at once (which some might think of as a possible rationale for what the government has done) but can hold off in order to maximise their sale value. Anglo Irish staff, furthermore, would not have the skills to act as a receiver or even as a “bad” or “collection” bank. The only (theoretical) logic for nationalisation that he could see, since we were in agreement that Anglo is not of systemic importance, is that there might possibly be spillover effects in terms of job losses etc. associated with widespread concurrent bankruptcies.
Since virtually the entire economics community is agreed that Anglo should have been let go, the question arises as to who is providing the advice that the government is listening to these days? Not Patrick Honohan obviously, though he’s right on their doorstep and has been dealing with financial crises for the last two decades. Is it the same PWC (as Martin Mansergh suggested on radio) who gave the banking system a clean bill of health as recently as last Autumn? I googled PWC yesterday and found them to be amongst the “soft landing” merchants of recent years. Why would the Finance and Central Bank economists’ perspectives differ so dramatically from the consensus reached by the rest of the public-sector economics community?
A question that academics will ultimately have to revisit concerns the (few) academic analyses of recent years that found property prices to have been largely driven by fundamentals. I remember commenting on one such paper to make the following point. The real interest rate used in the analysis was the nominal rate minus recent house price inflation. But if the latter were a bubble, the real interest rate would be underestimated and the fundamentals exaggerated. I didn’t find the explanation offered to be convincing.
At the time of writing, the Irish bank shares have fallen by about 50 per cent since last Friday’s closing price. The last time there was a one-day fall of comparable percentage size was at end-September, 2008 and it was immediately followed by the announcement of a blanket guarantee.
Let’s not have any knee-jerk reaction this time. The bank shares were already worth almost nothing, so there is scarcely any real impact of this price movement on the economy and on incentives.
Instead we need to have a process of confidence-building in the coherence and feasibility of the overall economic policy strategy for recovery. This must include a broad acceptance of the parameters of tax and spending policy, including on public sector pay. (Banking issues are only part of the equation and they will not be improved by sudden or half-baked initiatives.)
Previous posts have talked about public sector pay and restructuring the tax system. Getting a broad social consensus around an acceptable policy approach must surely be the priority. Here too, precipitate action will not be helpful. We need to know not only the government’s intentions; but that they will be seen as sufficiently effective and fair to elicit broad support rather than a general rejection and protest.