"US CDS above 100bps: it’s a MAD MAD MAD MAD World!
The recent widening in United States Credit Default Swap levels has gotten a lot of attention once it cleared the magic 100bps level intra-day.
As with any CDS-related news, you will get heated commentary in the blogosphere with a large perception of folks simply calling for all CDS trading to be banned. The general consensus appears to be “don’t the buyers of CDS realize that in the event of default by US, these contracts are not likely to be honored anyway?” This is Krugman’s line. Taleb chimes in with “It would be like buying insurance on the Titanic from someone on the Titanic”.
As with any heated commentary there’s bound to be a lot of misunderstanding of what this recent widening actually means and where it comes from. I’ll try to tackle this issue point by point below. For those of us with ADD (myself included) here’s a brief summary:
- Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen – I make this point in my AIG post. It follows that extrapolating any default information from wider CDS spreads can be misleading
- An apples-to-apples comparison of US CDS spreads suggests that $-denominated US CDS (the standard contract that is quoted in the news is the €-denominated one) should be trading at half the level it is now, perhaps making the recent news a lot less exciting
- The standard CDS contract is sufficiently complex so that the end-game buyers of CDS can be betting on something much more innocuous than a “default” such as a restructuring of privately negotiated tiny-size debt issuance
- Sovereign CDS (US included) has actually lagged both rising financial as well as systemic risk and has only now caught up, making the recent move largely expected
CDS is not a “default” trade – it is a “spread” trade
The most important point to be made here, the same one I make in my AIG post, is that, one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS.
I think the confusion largely stems from people viewing CDS akin to insurance. Though this is an easy analogy to make, it is, in fact, wrong. What motivates people when they buy fire insurance is that, in the unlikely case their house is consumed by a fire, they will get reimbursed. This is not what drives the CDS market.
There are two key differences between CDS and the insurance analogy:
- I don’t need to have a position in the entity’s bonds or loans in order to trade CDS on the same entity (while I do need to own the house I buy fire insurance on)
- As I mention above the vast majority of traders don’t trade CDS because of a view on default – they trade CDS because of their view on the level of CDS spreads expecting to lock in a MTM profit on the trade. Though you can probably save yourself some premium on fire insurance by installing sprinklers it’s clearly not as easy to do nor is it the primary motivation for fire insurance in the first place
Sovereign CDS is not a “fundamental” trade
I think one thing we can safely dismiss as the driver behind the widening of US CDS spreads, or in fact any sovereign spreads, in the market is any kind of fundamental view of where these spreads should be. The difficulty behind trading CDS on a fundamental default probability basis has to do with the fact that in order to put a number on an absolute default probability you need to have a firm view on: a) default likelihood, b) recovery upon default, c) devaluation of the local currency, to the extent that CDS you are trading is denominated in local currency.
Going through these in order
- It is actually difficult to have a firm view on the absolute default probability of any sovereign, particular, the United States. The fact is that developed sovereign defaults are relatively rare (outside of Spain’s relatively orderly 6 defaults within 100 years starting in the 16th century). As far as United States, my best guess is that we would need to go back to the Civil War to find a proper case of a “default”, though even here you would have to stretch. This was when the Confederacy issued cotton-backed bonds to finance the war against the North. Once the South lost New Orleans (making it impossible for South’s creditors to take physical delivery of cotton) and began to run out of cash, it became clear that it was only a matter of time before the Confederacy defaulted. By the end of the war the Confederacy’s “greybacks” were worth 1 cent on the dollar. The North refused to honor the Confederacy’s debts and the rest is history. In the 20th century developed sovereign defaults are relatively rare, especially after the World War II.
European defaults/restructurings in the 20th century (Rogoff)
- Getting a guage on expected recovery by a sovereign is not any easier. These range from the teens in Russia and Ivory Coast to 69% in Ukraine.
- Though much of protection traded on sovereigns is in a currency other than the local currency (i.e. Brazil CDS is traded in USD not in BRL), for local currency trades one has to be aware of the likely devaluation of the local currency in case of default. Those of us old enough to remember will recall the Argy peso going from 1 to over 3 in its peg to the dollar. I touch upon this in the Quanto CDS but suffice it to say that buying protection on Germany in EUR rather than USD means that €CDS levels should trade around half of $CDS levels.
The Quanto CDS
Though people like to focus on the round 100bps number, what’s mising from this is the fact that US CDS is traded in euros and that in order to do a proper apples-to-apples comparison to US-traded corporates you would need to first translate the EUR spread to a USD equivalent spread. This translation is largely a function of how much the local currency will devalued in the case of default (ignoring the small impact of rate, fx and credit volatilities and correlations). So, if you think that the dollar will weaken by 50% relative to the Euro in the case of a US default then the fair USD-denominated US CDS spread should trade around 50bps.
Do sovereign CDS trade in currencies other than the standard contract currency? In fact they do and the biggest market is in Latin American CDS denominated in local currency. If you think CDS is an “obscure” market, then this is the ultra-obscure one. It is largely driven by sovereign issuance of US-denominated debt that they swap to their local currency (in order to remove the stain of “original sin” ie non-local-ccy issuance). Normally, they would just do a simple USD/local-ccy interest rate swap. However, the trick is to do a clean asset swap instead which is simply an interest rate swap that is credit-linked to themselves which can save the country upwards of 100bps on the swap. Corporates in Europe and Latin America tend to do this “self-reference” trick as well – though it is illegal in the US.
For Latin American CDS, this local currency discount can be anything from 25-60% on 5y CDS (it varies depending on the tenor and tends to be downward sloping).
The “non-default” default
The word “default” has been thrown around a little too easily lately with respect to CDS contracts. The concept of default is, generally speaking, a very loaded one that brings to mind long bread lines, a crippled banking system and runaway inflation. In the context of CDS, the concept of “default” is a very specific one. For this reason, CDS language talks about a “credit event” rather than a “default” and can include such actions as restructuring of debt, repudiation of debt, moratorium and accleration. In summary, the following issues need to be considered in the context of Sovereign CDS.
- The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a) Failure to Pay, b) Repudiation/Moratorium, c) Restructuring. Latin American sovereigns add to this list Obligation Acceleration which was a near possibility when Hugo Chavez declared his country’s pullout from the IMF. The point here is that something like a restructuring of debt can be much more benign than an outright default (i.e. a failure to pay). So, a CDS can often price in a less dire scenario than the likelihood of “default”.
- Generally, anything counting as “Borrowed Money” can trigger a CDS credit event. This can often be a small privately negotiated loan rather than a large bond or loan trading in the market.
The Beta Issue
If you ask a Sovereign CDS trader why his names are wider today his likely response is “The index is blowing up, dude. Now do you have anything to do?” The simplest answer is that sovereign CDS is wider because everything is wider. And the simplest answer is often the right one.
Backstopping Financials
The move wider in sovereign CDS can be attributed to the expected covergence between sovereign and bank CDS spreads on the back of countries backstopping their financial systems. Countries have either bailed out certain institutions directly (Lloyd’s, RBS, ING, etc.) or have guaranteed bank deposits (Ireland, Germany,e tc.). While sovereign spreads have initially lagged the spreads of their financial systems, once it became clear that the sovereign was willing to underwrite the tail risk of their banks, it made sense for their spreads to converge. And if financial spreads refused to come down to the level of the sovereign, then sovereign levels would rise to the level of financial spreads. This was likely driven by two things: a) relative value trades of selling bank CDS and buying sovereign CDS betting on the convergence, b) continued buying of bank CDS as a hedge against bank paper. This led to sovereign CDS widening to the level of bank CDS rather than the other way around.
The Systemic Hedge
One way to understand the widening in sovereign spreads is by tieing sovereign risk to some other risk in the market that should be driven by the same views or needs. The typical buyer of sovereign CDS, apart from the marginal trader punting on Austrian eastern european exposure of the inability of Iceland to convince the world they’ve got things under control are the Investment Bank credit portfolio groups. These departments generally manage hundreds of billions of loan and derivative exposure across the bank. Their mandate is to protect the bank from an increase in non-performing loans. Normally, the counterparties to the loans do not trade in the market (either in CDS or stock) or are not liquid enough for the groups to go out and hedge in these assets. So, what they normally end up doing is buying systemic risk hedges in large size with the expectation that in the scenario a large portion of the bank’s loans goes bust, the world will be in such a state that their systemic hedges will offset the deterioration in the loan book. Though out-of-the-money S&P puts figure prominently in their hedges, in the world of credit we can look at a) super-senior spreads, b) financials spreads, c) sovereign spreads.
Assuming 40% recovery, the CDX super-senior tranche (30-100%) will be impaired after 40% of the CDX portfolio. Although it’s clearly difficult to envision the state of the world in this scenario, we can safely say the sovereign would be under pressure.
Why is U.S. Credit Risk News?
It is interesting that US credit risk is showing up on people’s radar at the moment when the “obscure” product like CDS is signaling it rather than the plain-vanilla Interest Rate Swap which trades in many multiples of volumes.
Sometime in early 2009, 30y interest rate swap yields rose above treasury yields. This price action suggested that the market viewed 30y Bank (AA) risk as safer than Treasury (AAA) risk. However, given the dire state of the Banks, this was clearly not the driver of the yield moves. What happened was that the exotics desks of the banks sold a huge amount of 2s/30s non-inversion notes to private bank investors that paid a high coupon as long as 30y swaps stayed above 2y swaps. The initial hedges done by these desks was to pay 30y swaps and receive 2y swaps. By the end of the year, rates had collapsed with 30y swaps falling more than 2y since the front end did not have as much room to rally. This meant the 2s/30s curve flattened massively causing the banks to partially unwind the hedges. In a period of poor liquidity every rates exotics desk was hitting 30y bids in size leading 30y swaps to rally beyond treasury yields.
So, though often painted as a credit risk issue, this episode was really a liquidity/technical problem.
Bring on the Technicals
Here, I briefly describe what, in addition to the above issues, could be the technical drivers of wider sovereign CDS, and US CDS in particular:
- Credit-Linked Notes Unwinds. As we all know retail investors are the best negative gamma traders. They buy high and sell low. It is not impossible that there were investors who were looking to add a few basis points to their “risk-free” trade by adding US CDS risk. It is also possible that as the crisis deepened they grew less comfortable with the risks in the trade and unwound them, suggesting that the origination desks needed to buy back the US CDS protection they initially sold, pushing CDS wider
- Liquidity in US CDS is not fantastic judging by two things: a) US dealers don’t trade it and b) the bid/offer spreads is 10bps or around 12% of the CDS spread. By comparison bid/offer spread in the CDX index (most liquid product in credit) is less than 1%. When you factor in these issues with the fact that in the current environment there are likely to be more buyers than sellers, you will see the CDS spreads widen to accommodate that
So, in summary, what do I make of US CDS widening? Well, not much apart from making it another cocktail conversation topic. Let’s revisit this issue once investors start discounting all their treasury holding by the US CDS spread… starting with China and their $1.7trn portfolio. Now that would give us something to talk about!"
Me:Don the libertarian Democrat says: Your comment is awaiting moderation.
On the US and defaults:
http://www.rgemonitor.com/globalmacro-monitor/255267/was_there_ever_a_default_on_us_treasury_debt
Was There Ever a Default on U.S. Treasury Debt?
Alex Pollock | Jan 23, 2009
“As the bailouts in the current bust inexorably mount, financed in rapidly increasing U.S. government debt, one might wonder whether a default on Treasury debt is imaginable. In the course of history, did the U.S. ever default on its debt?
Well, yes: The United States quite clearly and overtly defaulted on its debt as an expediency in 1933, the first year of Franklin Roosevelt’s presidency. This was an intentional repudiation of its obligations, supported by a resolution of Congress and later upheld by the Supreme Court.”
And:
“The clearest summation of the judicial outcome was in the concurring opinion of Justice Stone, as a member of the majority: • “While the government’s refusal to make the stipulated payment is a measure taken in the exercise of that power, this does not disguise the fact that its action is to that extent a repudiation.” • “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion, announced for the Court, that the government, through exercise of its sovereign power, has rendered itself immune from liability.” So five of the nine justices explicitly stated that the obligations of the United States had been repudiated. There can be no doubt that the candid conclusion of this highly interesting chapter of our national financial history is that, under sufficient threat, crisis and pressure, a clear default on Treasury bonds did occur.”
From you:
“The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a) Failure to Pay, b) Repudiation/Moratorium, c) Restructuring.”
My explanation was that the government would not default outright, but simply pay less on the debt, and that’s what’s being insured. I think that’s what you just said. Am I wrong?
And:
admin says:Well, yes: The United States quite clearly and overtly defaulted on its debt as an expediency in 1933, the first year of Franklin Roosevelt’s presidency. This was an intentional repudiation of its obligations, supported by a resolution of Congress and later upheld by the Supreme Court.”
Don, thanks for pointing this out. It’s pretty clear that the debt was somehow restructured which would potentially qualify under the current Restructuring clause of CDS. I wonder what the Recovery would be in this case, likely very high as I would expect in dollar terms the creditors to be paid in full (in dollars, if not in gold). This issue also speaks as to why US CDS is not denominated in USD as devaluation would add a wrinkle to fair value of protection. Though, clearly denominating CDS in euros is not that much better since the two currencies are so tightly linked.
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