Credit Default Swaps on Government Debt: Potential Implications of the Greek Debt Crisis
By Joseph Mason
While it is widely held that unprecedented monetary and fiscal policy responses of countries worldwide have been successful at preventing a worst case scenario repeat of the Great Depression, the combination of rising fiscal deficits and continued monetary policy accommodation has raised concerns about the sustainability of public finances and fears of inflation. As a result, the recent uproar about Greece’s fiscal woes and possible debt default are viewed by many as merely a “canary in the coal mine.”
It is hard to argue that Greece is not to blame for its difficulties. As of December 2009, Greece had the highest fiscal account imbalance as a percent of GDP of all the Euro-area countries and Britain, at -7.7%, and its projected 2009, 2010, and 2011 balances were second only to Ireland. With a long history of fiscal stress and previous defaults, investors are right to be suspicious.
Moreover, the market for sovereign CDS is much smaller than the underlying market for government bonds. None of the data can possibly lead to a conclusion that a market of $9bn can dictate prices in the $400bn government market. As of this hearing, Ireland, along with Italy and Portugal, are being pressured for similar good reasons.
Defaults are nothing new, even for sovereign entities and municipalities. There exists a long history of defaults throughout world, as well as US, history. The definitive guide to the history of US state and municipal defaults shows that even in the Great Depression, states with serious default problems took on far more debt in the decade than states that had no defaults. Hence, even historically, default is not a threat without a substantial debt load.
More recently, S&P reports that the five-year transition rate for AAA-rated local and municipal debt over the period 1975-2009 was 27.4%, with 10.9% of that resulting from ratings that were withdrawn and 16.4% resulting from ratings that were downgraded. For local and municipal debt initially rated BBB, only 48.9% remained BBB at the end of the five-year period. 12.9% had been upgraded to A, and 11.8% downgraded to BB and B. 26.4% of initial BBB ratings had been withdrawn, completely. S&P reports that the sovereign speculative grade-rated fifteen-year default rate over the same period was 29.66%. The point is, sovereign defaults happen.
A real problem in the sovereign CDS market, however, arises because of the concentration in counterparty risk. Whether that concentration is at a central counterparty or a small group of market participants, the risk remains. Recently, the IMF has opined that the magnitude of risk to be assumed at the proposed CCP is of an order of magnitude in the neighborhood of some $200 billion. That estimate should not be dismissed or the amount will surely precipitate a future crisis.
Some have pointed to CDS as creating problems for sovereign debt financing. It is hard, however, to see the case. While CDS provide transparency by aggregating market views of the probability of default and recovery, CDS – in and of themselves – do not create additional volatility to those views.
The view of CDS as creating volatility comes from observations that CDS spreads can widen quickly before a credit event, reflecting demand from CDS protection buyers. Some of the fear arises because CDS markets may be dominated by fast-moving hedge funds, while cash bond markets are dominated by buy-and-hold real money investors. While it can seem that the signals from the two markets may be at odds during distress, the apparent divergence has been shown to be bounded by some fundamental institutional and value distinctions between CDS and the underlying debt contracts.
It should also be noted that, 45% of the respondents in the 2009 Fitch Global Credit Derivatives Survey disagreed or strongly disagreed with the view that the availability of CDS had lowered loan underwriting standards. That observation supports the view that institutions use CDS primarily as a trading instrument and as a means of taking a position in the credit markets rather than as a hedging tool for their loan books.
Overall, the danger that a CDS buyer may deliberately trigger a credit event remains theoretical. There are no known cases of adverse behavior that had directly impacted debt borrowers because those borrowers are known to be struggling financially, anyway.
In sum, therefore, I am not convinced sovereign CDS deserves its current negative press, and fear that a ban or restriction on trading could easily backfire. Bans on trading activity tend largely to reduce liquidity, forcing a reversion to a world where sudden and unhedgeable price jumps occur when information about underlying fundamentals is occasionally priced into an illiquid market – that is, when someone finally trades. Sovereign CDS provides an efficient way to trade – and to hedge – credit exposures to governments, as well as a more continuous way for governments to “poll” their fiscal decisions more continuously in the marketplace. If governments do not like that transparency, it seems they doth protest too much.