Credit Default Swaps: Useful, Misleading, Dangerous?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

 

Richard Portes, in a recent VOXEU communique (April 30^th), asks this question about the use of Credit Default Swaps (CDSs).  In particular, the use of naked CDSs may actually increase rather than decrease systemic risk.

 

CDSs are derivatives – financial instruments sold over-the-counter (OTC) that transfer only credit risk (corporate or sovereign bonds) to a third party.  The purpose of the CDS contract is to provide a form of insurance for an asset held by investors against default losses.  These contracts offer payment on default of a financial instrument, even if the buyer of the contract does not own the asset – a “naked” position.  This has evolved from the original use of the CDS contract that provided insurance against unexpected losses due to default by a corporate or sovereign entity. 

 

The CDS buyer who desires this protection pays a premium of the asset’s nominal value, in basis points, to a counterparty or protection seller expressed as a spread.  European politicians blamed the CDS market for destabilizing Greece.  As a result, a new EU regulation was implemented that restricts the use of “naked” CDS positions on sovereign debt. 

 

The gross notional value of these contracts stood at US$15 trillion during the third quarter of 2011, with the majority held on corporate debt.  Portes notes the CDS market is a useful innovation when it can provide efficient isolation of credit risk, and is not dominated by naked speculative CDSs positions that are not being used for hedging purposes.

 

CDS contracts can provide a useful function for price discovery and hedging positions.  However, he notes that early research on CDS markets were done with limited data and produced mixed results on how the market functioned.

 

Portes notes that price deviations can exist in the short-run as CDSs adjust more quickly to news than the cash market.  He notes that the derivative CDS market usually moves ahead of the bond market in price discovery, both before and during the financial crisis.  In addition, he noted that deviations from a long-run equilibrium could persist between market prices than would normally be anticipated. 

 

Like most financial innovations in recent years, naked CDSs are said to be beneficial in a move toward more complete markets.  However, a key lesson from the financial crisis is that innovations can be dysfunctional and dangerous.  In this case, naked CDS positions, however, may increase systemic risk.   Perhaps the lesson is that by making instruments more complex, we can increase risk and need to limit their use until we have a better understanding of how this market functions.

 

For more on this follow the link:  www.voxeu.org/index.php?q=node/7922

Confronting and Managing Risk

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

 

The recent confrontation between Greece and EU officials provide a good lesson for risk managers.  EU officials continue to minimize potential risks, fail to take realize their magnitude and communicate the problems, and take the necessary steps to remedy the situation.  These are all symptoms of a failure of risk management.  

 

Greek Prime Minister Papandreou made a stand, against the proposed Greek debt restructuring, and even though he was forced to backpedal, Wyplosz argues that he did the Eurozone a favor by providing it an opportunity to change course.  The Greek government has largely been following the dictates of EU officials to not restructure their debt, but this might have been the least costly remedy if done in a timely manner.  

 

The Greek revolt, even if short lived, is good news on the European crisis front – it might provoke the long-awaited policy turnaround that is necessary to end the Eurozone crisis.  It may finally awaken Eurozone leaders to the futility of the path they’ve chosen.  One way or another, a disorderly Greek default is in the cards with its attendant contagion for all of the rest of the PIIGS (Portugal, Ireland, Italy, and Spain) and maybe even France.  The cost of a default could be much larger than delaying the inevitable Greek restructuring.

 

Dazed and Confused?  Eurozone officials took the wrong path in early 2010, because they did not fundamentally understand the nature and depth of the problem.  Perhaps, they did not want to deal with it and brazenly assumed things would revert back to normal.  However, the seriousness of the surging debt and slow growth revealed all the flaws hidden in the euro’s first ten years.  There is a cost for their negligence. 

 

At that point a real solution is inevitable – one that requires Eurozone leaders and the ECB to play on the same side with credible rules for all.  An ECB backstop for Eurozone bonds will be required, but this does not mean underwriting banks and sovereigns. The ECB guarantee should be set to protect the ECB and to force a debt restructuring for countries that face unbearably high interest rates. 

 

Banks will have to be bailed out, possibly with EFSF resources, but in a way that minimizes moral hazard and maximizes taxpayer protection.  That means wiping out shareholders and, if need be, unsecured bondholders.  The cost of the bailout could reach into the hundreds of billions and does not include recapitalizing financial institutions.  A long-term cost is the sustained period of sub-trend growth resulting from the overhang.

 

Can we learn anything for risk management?

For more on this follow the link:  http://www.voxeu.org/index.php?q=node/7222

Issues that need to be addressed to reduce European sovereign risk

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by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

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European leaders face a deadline this Sunday to implement policies to help resolve the sovereign debt crisis.  A review of these issues is summarized in a recent commentary.

 

A deadline for solving a deadly Eurozone sovereign debt crisis (Guillermo de la Dehasa, VOXEU October 20^th) Time is running out for EU leaders to put an end to the Eurozone crisis.  European leaders face the following issues: 1. find a definitive solution to Greek insolvency, 2. isolate solvent countries from possible Greek contagion, 3. improve EU governance by creating a true European Parliament and 4. refocus on a pro-growth policy mix. 

 

Eurozone leaders must reach a clear and definitive solution to Greece’s insolvency without triggering a credit event.  Private sector involvement is not the best solution since “voluntary haircuts” can be an oxymoron and impede decisions.  Haircuts can be imposed on banks and a Brady-like swap program can be implemented for Greek bonds into European Financial Stability Facility (EFSF) bonds of longer maturities.  A challenge for policymakers is to isolate solvent members from contagion.  The can be implemented through a backstop for Eurozone member debt, such as a leveraged EFSF.  The guarantee is implemented in return for debt consolidation and structural reforms. 

 

Long-term, the present structure of European governance and crisis management needs to be addressed.  This issue can be resolved by amending the treaties and moving away from the current system where council decisions need unanimous approval within national governments.  Long-term, the EU needs to move to a federal system of governance by a true European parliament.  It should set up an independent European treasury to monitor states compliance to debt limits and structural reforms.  Lastly, policymakers need to implement a policy where Eurozone growth rate can exceed the real interest rate on its debt.

 

European banks will need to be recapitalized.  However, this will only be a stop gap measure without addressing the other issues.   Otherwise the concept of the euro will be at risk.    

 

Extreme Financial Risks & The Eurozone

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

“An error does not become truth by reason of multiplied propagation, nor does truth become error because nobody sees it.”  (Gandhi)

 

The point is that the emphasis of Eurozone policymakers focus on a stop gap liquidity facility rather than solvency can have long-term consequences.  This is illustrated in the following communiqué (The Future of the Eurozone (VOXEU, Konrad & Zschapitz, June 10^th)) on the outlook for the Eurozone.  

 

A year has passed since the initial bailout of Greece. The Eurozone is still on life support, the authors argue, including the view that Europe’s policymakers have got their strategy desperately wrong.  The failure to modify the Stability and Growth Pact to account for macroeconomic imbalances is a move in the wrong direction.  They treat the bailout as a temporary liquidity problem and not a solvency issue, which will ultimately increase the costs of the policy error. 

 

The authors note two options, which while considered, are not deemed viable.  The first would be the reversal of the socialization of private sector debt and funding from other ECB members to finance budget deficits – a return to national fiscal responsibility.  The economic cost of restructuring would have a large economic cost to all countries.  A second alternative is the use of “financial repression.”  This is when governments adopt measures to channel funds to themselves that may go elsewhere in unregulated markets.  This method is particularly effective at liquidating excessive government debt.  However, from an economic efficiency standpoint, it makes little sense for banks to use their funds to invest in government bonds unless it is part of their shareholder mandate.

Reinhart and Sbrancia (2011) characterize financial repression as consisting of the following key elements:

1. Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2. Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.
3. Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

The authors consider following the current option of intergovernmental transfers as a means to avoid debt default or restructuring.  However, the sums required to make this viable would not be considered acceptable to taxpayers. The most likely outcome is a breakdown of the Eurozone prior to reaching an endpoint as policymakers focus on stop gap liquidity facility rather than deal with the solvency issue.   One possible reason for this breakdown is a rise in political tensions among member countries. A second, more likely outcome is a breakdown in the Eurozone as political tensions increase and investors lose confidence in the sustainability of the Eurozone as a whole.

 

For more information on this subject, click on the link:

http://www.voxeu.org/index.php?q=node/6628

 

Note: Because of it's relevance today, this is a re-posting of a blog that originally appeared in June

 

The Risk of Contagion in Europe – Evidence from Credit Default Swap Spreads

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The majority of analysts suggest that Greece is insolvent.  The issue for investors and risk managers is whether Greece’s troubles are contagious.  The authors lay out a framework to test whether Greece’s troubles can cause contagion.    

Investors and policymakers are split into two views on dealing with Greece: the bail-in-ers want a coercive (but soft) restructuring of Greek debt while bail-out-ers favor procrastination with continued EU-IMF lending to Greece.  There is no disagreement about whether Greece is broke.         The argument among in-ers and out-ers hinges on the fear of contagion or spill over into other markets.  There is concern that investors could over-react and flee Spanish and Italian debt forcing a European sovereign debt and banking crisis. This could force the choice between a full-blown monetization and/or a break-up of the euro.

The first test the authors perform is to look at the volatility of five-year European peripheral country Credit Default Swaps (CDS) spreads breaking it into a euro-wide and country wide spread component.  The euro-wide spread component has been declining for most of 2011 indicating a lower degree of “EU-bundling” of sovereign risk.  A second test looks at the factor weight of Greek CDS spread in a Euro-wide component. The factor weighting has declined significantly in the Euro-wide spread this year.  The last test shows that the correlation between Italian and Greek CDS spreads has declined steadily since late 2010. 

The evidence suggests that contagion has become less likely today than the past couple of years.  Markets bundled EU sovereign risks together for a long-time, but recently financial markets are starting to discriminate more.   There are two potential conclusions: the orderly restructuring of Greek debt should not produce an investor panic out of EU debt and second the fate of other problematic countries such as Italy rest in their own hands.  Risk managers need to be cautious, but the research suggests that fear of contagion may be overdone. 

 

For more on this issue, click on the link to VOX :The fear of contagion in Europe”, Manesse & Trigilia:  http://tinyurl.com/6ep63ha 

 

Dazed and Confused - Managing Foreign Exchange Risk & the Greek Debt Crisis

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

The stakes continue to remain high in Athens as Greece’s economic rescuers attempt to craft another bailout facility.  Demonstrators, while angry, continue to be dazed and confused, and so are investors.  However, if talks breakdown it can have catastrophic consequences for Greece, the euro and the financial system.  The Greek banks and government would run out of money, cause a sharp euro downdraft and severe financial contagion.  The addition of another liquidity facility only postpones the day of reckoning.  Even if the new facility appeases the bears, the fundamental problem remains is that the country remains uncompetitive in global markets.  It will take years of painful structural reforms to restore competitiveness.  Investors with Greek or euro exposure may have to take a painful haircut much as investors in Argentina did in 2001.      

Despite the confusion in the streets, there remains a number of questions about the size of the package, of euro 119 billion (about US $120 billion) and the future viability of the Greek economy in its current state.   There seems to be a mistaken belief by Greek politicians, that the would be rescuers, would make available another euro 120 billion (or more) in 2012 to provide relief through 2014.  This would allow the new EU stability mechanism an opportunity to provide needed relief.  However, it seems to ignore the view of investors, the need for assistance to other countries and the recapitalization/restructuring of European banks. 

In addition, there are a number of challenges in German courts that the facility is “bridge-financing” and does not violate the “non-bailout” clause in the German and European Constitution.  However, analysts do not expect the court to rule the bailouts as unconstitutional, but the uncertainty surrounding the situation adds to potential risks.

In addition while Greek CDS spreads are near record levels, there seems to be further confusion as to what constitutes a default.  Rating agencies consider any type of debt restructuring, reprofiling, or even a voluntary rollover of maturing debt as a potential default.  However, a rollover according to the International Swap Dealers Assn. (ISDA) may not trigger a credit event.  European officials are trying to get around rating agencies’ reservations about a rollover so as to not to trigger a default or credit event.

The depth of the recession is taking a severe toll on the Greek economy as the economy could shrink by 4% in 2011, after falling over 4.5% in 2010.  The politicians continue to defend the welfare state and admit the medium-term budget targets are not achievable.  There is a growing concern that if the fractious politicians cannot make unpopular decisions – how can they avoid bankruptcy?  Dazed and confused - do you know your potential risk exposure?  

Who’s Came First?

By Stephen McPhie, CA

Partner, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com 

Pete Townshend (of the band The Who fame) has done well out of the TV show CSI’s title songs.  He could carry on in that vein with theme tunes for sovereign debt crises.  Who’s Next, Who Came First, Who’s Last, …. and some others.

 

Seems that Greece is everyone’s favourite (sic) Who Came First candidate.  When will a Greek default become official?  Or how long can a fudge be maintained so that politicians can fool themselves into believing there will be no default?  The market sees default with Greek debt yields climbing towards 20%.  Nobody with some form of conventional content inside his or her head really believes that Greece will ever be able to repay its current debt load and most believe that some sort of restructuring is inevitable.  The only question is when.

 

It seems that here will certainly be another bail out and possibly one after that.  However, sooner or later reality must and will be faced.

 

And if Greece defaults, who'a next?  Portugal?  Ireland?  Spain?  Italy?  And if Greek debt gets restructured and partly forgiven, will there be a line of countries wanting the same treatment?

 

And what does this mean for the Euro and how isolated would the effect be?

Extreme Financial Risks & The Eurozone

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

“An error does not become truth by reason of multiplied propagation, nor does truth become error because nobody sees it.”  (Gandhi)

 

The point is that the emphasis of Eurozone policymakers focus on a stop gap liquidity facility rather than solvency can have long-term consequences.  This is illustrated in the following communiqué (The Future of the Eurozone (VOXEU, Konrad & Zschapitz, June 10^th)) on the outlook for the Eurozone.  

 

A year has passed since the initial bailout of Greece. The Eurozone is still on life support, the authors argue, including the view that Europe’s policymakers have got their strategy desperately wrong.  The failure to modify the Stability and Growth Pact to account for macroeconomic imbalances is a move in the wrong direction.  They treat the bailout as a temporary liquidity problem and not a solvency issue, which will ultimately increase the costs of the policy error. 

 

The authors note two options, which while considered, are not deemed viable.  The first would be the reversal of the socialization of private sector debt and funding from other ECB members to finance budget deficits – a return to national fiscal responsibility.  The economic cost of restructuring would have a large economic cost to all countries.  A second alternative is the use of “financial repression.”  This is when governments adopt measures to channel funds to themselves that may go elsewhere in unregulated markets.  This method is particularly effective at liquidating excessive government debt.  However, from an economic efficiency standpoint, it makes little sense for banks to use their funds to invest in government bonds unless it is part of their shareholder mandate.

Reinhart and Sbrancia (2011) characterize financial repression as consisting of the following key elements:

1. Explicit or indirect capping or control over interest rates, such as on government debt and deposit rates (e.g., Regulation Q).
2. Government ownership or control of domestic banks and financial institutions while placing barriers to entry before other institutions seeking to enter the market.
3. Creation or maintenance of a captive domestic market for government debt achieved by requiring domestic banks to hold government debt via reserve requirements, or by prohibiting or disincentivising alternative options that institutions might otherwise prefer.
4. Government restrictions on the transfer of assets abroad through the imposition of capital controls.

The authors consider following the current option of intergovernmental transfers as a means to avoid debt default or restructuring.  However, the sums required to make this viable would not be considered acceptable to taxpayers. The most likely outcome is a breakdown of the Eurozone prior to reaching an endpoint as policymakers focus on stop gap liquidity facility rather than deal with the solvency issue.   One possible reason for this breakdown is a rise in political tensions among member countries. A second, more likely outcome is a breakdown in the Eurozone as political tensions increase and investors lose confidence in the sustainability of the Eurozone as a whole.

 

For more information on this subject, click on the link:

http://www.voxeu.org/index.php?q=node/6628

The Failure of Risk Management: A Preliminary Look at the Cost of a Greek Bailout

Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

European politicians, when creating the euro, failed to consider the risks of their actions.  Policymakers looked at developments in Greece as a temporary liquidity squeeze rather than a solvency crisis.  Paolo Manasse wrote on this issue in a voxeu communiqué called “Greece, The Unbearable Heaviness of Debt”.   He noted analysts have been arguing that Greece will default on part of its debt – leaving its creditors to take a “haircut”.  Manesse argues the prospect is becoming more likely.

 

S&P further downgraded the junk rating of Greek debt reflecting the larger than projected budget deficit and the unsustainable growth rate of government debt.  They estimate a 50% haircut may be required to restore solvency.  There are expectations of a euro 50-60 billion loan from the EU/IMF, which at best may provide temporary relief.  Currently, the only other alternative to debt restructuring, is to leave the euro which seems extremely unlikely.  The rising interest rate on Greek debt combined with new debt issuance/borrowing indicates that the stock of debt is growing much faster than GDP, which is not sustainable.

 

Currently, there are three potential tools to make Greece’s debt sustainable: lowering the interest rate on outstanding debt, turning the primary deficit into a surplus, or writing down the existing debt stock.  A reduction in the market rate may provide a cushion for Greece.  Any move to a primary budget surplus would most likely cause social unrest.  The most likely scenario would be restructuring plus new money at a concessionary rate.  Eurozone bank exposure to sovereign Greek debt is estimated around $100 billion according to the BIS.  Any write-down of Greek debt along with the need to recapitalize the banks will be an expensive lesson on risk management.

The Underpricing of Risk – What Can We Learn?

by Don Alexander, MBA

Associate, RSD Solutions Inc.

www.RSDsolutions.com

info@RSDsolutions.com

 

Jeffrey Frankel, in a recent Vox communiqué called “The ECB’s Three Mistakes in the Greek Crisis and How to Get Sovereign Debt Right in the Future”, reviews the failure of the European Central Bank (ECB) and policymakers to fully integrate Greece into the Euro and fulfill the necessary conditions for membership. .

 

The first mistake, by the ECB and the European Commission, was to allow Greece to join the Euro in 2000 when it failed to meet the economic criteria established by the Maastricht Treaty, particularly the 3% ceiling on the budget deficit expressed as a share of GDP.  The second failure by European authorities, was to monitor budget deficits and debt levels that exceeded limits established by the Stability and Growth Pact, resulting in Greek borrowing costs similar to that of Germany.  As a result, international investors grossly underestimated potential risks.   The third mistake was not to send Greece to the IMF earlier.  European policymakers looked at the events in Greece as a temporary liquidity crisis rather than outright insolvency.  The result is a higher cost for a bailout.

 

There are two major lessons learned by policymakers from the Greek experience.  The first is that when specific criteria are established, such as the Maastricht fiscal criteria and the No Bailout Clause (1991) and the Stability and Growth Pact (1997), someone has to take responsibility for monitoring and enforcing them. The second lesson is that European authorities are not equipped to impose policy conditionality in rescue loan packages; this is the IMF’s job. International politics is less likely to prevent the IMF from enforcing painful fiscal retrenchment and other difficult conditions. Europe is no different in this respect than Latin America or Asia.

 

The failure to price risk correctly is now resulting in European policymakers discussing the possibility of a “soft restructuring” of Greek debt.  The term soft restructuring is used as a euphemism for extending the maturity of outstanding debt.  European authorities are looking for further spending cuts and increased privatization by Greece.  However, the failure to do the large-scale debt restructuring, increasingly demanded by investors, will increase the ultimate costs.