Contagion: Default probabilities blow out right across Europe

Look at this chart of the sovereign credit default swap wideners today. Every single name is European. The only one with a sub-10% default possibility is Sweden, and they are not in the euro zone. That tells you something, doesn’t it? I think Warren Buffett is on to something.

I like CDS as a gauge of market distress. For example, Belgian, French and Spanish CDS are at record highs. That tells you contagion is getting worse.

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But these sovereign CDS are products that are dangerous though. Europe has already eviscerated the sovereign CDS market with its ‘non-default’ in Greece. The Council on Foreign Relations agrees.

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Imagine life insurance contracts that wouldn’t pay off if officials declared heart attacks to be “voluntary.” Welcome to the world of sovereign credit default swaps, or CDSs. When the Greek debt deal was announced on October 27, the eurozone leadership insisted that the banks were taking a 50% write-down “voluntarily,” meaning that Greek CDS contracts would not be triggered. This was done to protect official creditors like the ECB and IMF, to avoid rewarding speculators, and to prevent possible financial contagion. In response, Greek CDS prices plunged 20 percentage points.  Policymakers didn’t seem to care, but they should.

I agree 100%.

CFR also believes we should kill sovereign CDS off. CDS in general were called weapons of financial mass destruction for a reason. SO I am sympathetic to the concept of neutering them they way the Europeans did. However, we see that doing so has had negative unintended consequences. Trying to shoehorn a 50% haircut for private sector creditors into a non-default event is crazy. There was nothing voluntary about it since the Troika and ECB didn’t take cuts. These CDS are now almost useless except as a fear gauge. You might as well sell euro paper now and ask questions later.

The best way to get rid of CDS is to regulate them tightly – ban naked CDS, ban future sovereign CDS – and slowly strangle the market until existing contracts expire. CFR agrees:

Given the permanent political distortion that Europe has introduced into the sovereign CDS market, it would be best now if the market could simply be shuttered.

Source: CMA

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9 Comments
  1. Anon says

    How were private individual investors forced to take a haircut? If you are holding Greek bonds you don’t have to accept those terms – just hold the bonds and they will pay when they mature.

    Why should this be a CDS event?

  2. Anon says

    How were private individual investors forced to take a haircut? If you are holding Greek bonds you don’t have to accept those terms – just hold the bonds and they will pay when they mature.

    Why should this be a CDS event?

  3. Junh Haskell says

    @ Anon- Edward is assuming that the Greek debt holders will just hand over their money “voluntarily.”  

    However that is why hedge funds like Elliott Associates exist – to make it painful for sovereigns to commit this kind of daylight robbery.  

    Charles Dallara, who “agreed” to the “voluntary haircut,” can no more bind bondholders than the Pope.  It’s all a bunch of hot air.

    1. Edward Harrison says

      I don’t assume that. The European policy makers do, however.

      1. Anonymous says

        But you claim that CDSs not paying on the Greek haircut is somehow bad.

        What is your basis for that claim? If you held Greek bonds then you were not forced to take a haircut – so why should this be a CDS event?

        I’m trying to understand your reasoning. Every bond holder has the option to keep their Greek bonds and be paid in full.

        1. Edward Harrison says

          The CDS not paying out will cause bond yields to increase because they are now seen as providing inadequate protection in the event of a default.

          Also, do not use a fake e-mail address to post comments here because they will be spam blocked.

          1. David Lazarus says

            It still does not resolve the problem of excessive debt across the world. If we have a series of credit events that wipes out the big banks then it will clear much of the debt, and destroy the CDS market at the same time. No bank will write such policies because of the significant downs risks. Then it will be much easier to regulate because the banks that fund Congress will be bankrupt.

  4. Anonymous says

    @ Anon- Edward is assuming that the Greek debt holders will just hand over their money “voluntarily.”  

    However that is why hedge funds like Elliott Associates exist – to make it painful for sovereigns to commit this kind of daylight robbery.  

    Charles Dallara, who “agreed” to the “voluntary haircut,” can no more bind bondholders than the Pope.  It’s all a bunch of hot air.

    1. Edward Harrison says

      I don’t assume that. The European policy makers do, however.

      1. Anonymous says

        But you claim that CDSs not paying on the Greek haircut is somehow bad.

        What is your basis for that claim? If you held Greek bonds then you were not forced to take a haircut – so why should this be a CDS event?

        I’m trying to understand your reasoning. Every bond holder has the option to keep their Greek bonds and be paid in full.

        1. Edward Harrison says

          The CDS not paying out will cause bond yields to increase because they are now seen as providing inadequate protection in the event of a default.

          Also, do not use a fake e-mail address to post comments here because they will be spam blocked.

          1. Anonymous says

            It still does not resolve the problem of excessive debt across the world. If we have a series of credit events that wipes out the big banks then it will clear much of the debt, and destroy the CDS market at the same time. No bank will write such policies because of the significant downs risks. Then it will be much easier to regulate because the banks that fund Congress will be bankrupt.

  5. yo says

    Also, unstated, is that the chart you show is rendered almost meaningless. If they can’t collect, people won’t pay for them. 
    So, the default risk is almost certainly substantially higher than the chart suggests.

  6. yo says

    Also, unstated, is that the chart you show is rendered almost meaningless. If they can’t collect, people won’t pay for them. 
    So, the default risk is almost certainly substantially higher than the chart suggests.

Comments are closed.

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