CDS: Just Another Evanescent Bubble?

More on the Greek debt crisis from Naked Capitalism: German Paper Says AIG May Have Sold CDS on Greece. That German paper would be the excellent business-sheet Handelsblatt, and the full translation of the article into English which that blog’s proprietor requests in her post follows after the jump.

UPDATE: Correction! Looking at that original German piece, it clearly comes originally from the Frankfurter Allgemeine Zeitung or FAZ – often called Germany’s own New York Times. I have noticed before how the two papers clearly have an arrangement allowing Handelsblatt to reprint certain FAZ material. Credit where it is due . . .

The fever-curve of the Greek debt crisis
By Markus Frühauf
20 February 2010

Trade in the risk of Greek insolvency in the past five months has enabled fantastic earnings. That is made clear by the price-development for credit-default insurance on that financially-weak Euroland. On 16 October 2009 a Credit Default Swap (CDS), which investors use to insure themselves against insolvency from Athens, still cost 123 basis points (1.23 percentage points). This meant a yearly premium of 12,300 euros in order to insure a claim on 1 million euros. On 4 February the insured had to pay 42,820 euros for that, a fee three times as high. Greece’s risk-premium – in market jargon the CDS spread – is the fever-curve of the debt crisis.

For the growth in the expense of the insurance against non-payment reflects the reduced creditworthiness of the country. Speculation in the CDS market began after 4 October 2009, as the Greek Socialists celebrated their election victory. Two weeks later the newly-elected government informed its Euro-partners that the deficit for 2009 was going to lie at 12.7 percent of economic performance (GDP).

Timidly, but steadily
That was a shock, since the previous conservative government had prognosticated precisely half of that. The new estimate for the budget deficit called onto the stage the first hedge funds, reports a London CDS-dealer working for a large American bank. In view of Greece’s previous history of cheating its way into the monetary union with false budget statistics, at that point a wager on Greece having payment problems was promising. This bet in the meantime has become obvious.

The rise of the Greek risk-premium at first still continued timidly, but steadily. It could be that that hedge funds had been the first to recognize Athens’ exhausted budget situation but had bet in the CDS market on a fall in the value of Greek debt with little commitment of capital. But the new Greek government’s commitment to transparency unleashed this speculation. The further rises in the CDS spread were accompanied by fundamental factors as well. On 8 December 2009 the Fitch rating agency downgraded Greece’s credit-rating from “A-” to “BBB+”. The Euroland found itself in the same category as Estonia or South Africa in its credit-worthiness. One week later Standard & Poor’s followed. Here, too, the Greeks flew out of the “A-” class denoting particularly good solvency. In this period the CDS price exceeded the mark of 200 basis-points for the first time. With these rating-downgrades the fear of a possible Greek insolvency grew by leaps and bounds on the financial markets and among Europartner countries.

Unusually high interest-coupon
A first high-point was reached when the Greek finance minister issued a new five-year loan at the end of January. The offer of 8 billion euros encountered a demand among investors three times as great. This was a calming signal only at first glance. For Greece had to fit out the loan with an unusually high interest-coupon of 6.1 percent. With this the country was playing with a risk-premium in a league with Vietnam. This fed doubt on the debt market as to whether Greece under these conditions could sustain its debt-service over the long-run – in the first instance when in April and May 20 billion euros will have to be refinanced.

Besides all that, this led to a technical effect. The old loans already on the market still bore a lower interest-coupon. They were issued back when the credit-rating for Greece still lay in the “A-” range. Some investors were forced to shift into the new debt instruments with the higher interest. In the wave of selling the yield on ten-year Greek debt increased to over 7 percent. Whoever in October had bet on Greece having payment difficulties was now rewarded: the CDS spread now clearly lay over 400 basis-points. The initial investment had more than tripled when the payment-protection was sold on.

The CDS market is influenced by the same factors as the debt market. This was evident from the falling-back of the CDS premium when signs of financial support for Athens from Europartner countries multiplied. But the problem with the CDS is that this market is much more opaque. These contracts are handled over-the-counter among banks, thus in an unregulated environment. You can also speculate much more favorably aided by credit-default derivatives than on the loan market, for there is a significantly lesser commitment of capital required.

In any case, the CDS-wager has gone up because more and more true-believers in the Greek State have come to feel the need to insure their holdings. This rapidly-rising demand for insurance has been set off by the escalation of the debt crisis. But it is past Greek governments that have to answer in the first place for the exhausted budget situation. The higher demand for insolvency protection that has driven up the CDS price follows from the evidently poorer estimation of Greek credit-worthiness.

Greek banks as insurers
On the other hand, whoever expected Greece’s rescue by Europartner countries would have had to position himself on the CDS market as an insurer, that is, as a seller of payment protection. The take in premiums from insurance protection sold provides increased revenue. But it’s on the seller-side that the weak points of the CDS market become evident. It’s still unclear who has sold insurance protection for Greece. In one study analysts from the major French bank BNP Paribas referred to market-rumors that Greek banks had insured a large sum by CDS. If this is correct, then the payment protection they have provided is worth nothing. Greek banks hold State debt of over 40 billion euros. This corresponds roughly to the entire amount of equity in the Greek credit market. A bankruptcy of the State would lead to a collapse of the banking system.

London investment bankers name AIG as a further CDS-seller. That company had to be nationalized during the financial crisis due to its having written insolvency insurance on American mortgages. This debt-load would have led to the collapse of the world’s biggest insurer. Prior to the financial crisis AIG is said to have widely held State credit-risk. If yet-larger insurance positions on Greece exist, then the American government would have a strong interest in preventing that country’s insolvency.

Even if these are mere rumors about the Greek banks and AIG, this example makes clear the weakness of CDS markets. This protection is sold by banks or insurers who themselves have access only to limited capital resources. They have as a rule clearly lesser credit-worthiness than the states for which they are selling insolvency protection. Insurance by CDS could turn out to be just a bubble.

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