Are you ready for the sovereign CDS short selling ban? October 28, 2012 at 9:44 am
The implementation date, as the Bond Vigilantes remind us, is 1st November, and boy is it having an impact on spreads:
Category / Sovereign Default
The implementation date, as the Bond Vigilantes remind us, is 1st November, and boy is it having an impact on spreads:
Back in May last year, I wrote:
Greek CDS typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?
People are now waking up to this. FT alphaville for instance says today:
…Old R trades won’t have bucketed auctions even when the credit event in question is a restructuring.
So the question becomes whether anyone wrote CDS contracts with anything other than Old R trades on Greece. If there are MR or MMR trades there would have to be an auction with buckets.
Now, FT Alphaville didn’t think anyone had MR or MMR trades on Greece. Or, if they did, we thought it would be a booking error that would be cleared up.
But then, we saw this in a note from JP Morgan on February 24th (emphasis ours):
A problem might arise with the CDS contracts that have Mod R or Mod Mod R clauses. Western European sovereign CDS generally use the clause “Old Restructuring” (Old R). Under Old R, there are no maturity limits on deliverables, hence for the majority of the Greek CDS contracts currently in place there will be a single auction with bonds up to 30y maturity deliverable without multiple maturity buckets. But there is a small portion of Greek CDS contracts with Modified Modified Restructuring clauses (Mod Mod R), which means that for these contracts there will be several auctions for multiple maturity buckets. For the settlement of these CDS contracts, there might be bond deliverability shortage for shorter maturity buckets up to 10 years, where only international law bonds will be deliverable, creating some room for a squeeze in the auction process. But again, the universe of these CDS contracts (Mod Mod R) is rather small.
Now, that’s weird.
That was the first we’d ever heard of Greece CDS trades with MR or MMR. And we’re still thinking that someone at some point made a mistake.
Not necessarily. Restructuring is just a convention. You can negotiate whatever you want. Maybe someone needs restructuring to get capital relief*. Maybe they are doing a basket and they want the same restructuring choice on all the names in the basket. Maybe they just ticked the wrong box. But once you have agreed to, say, MMR, changing it to Old R is going to cost something. Pretty soon we’ll see if it was worth paying or not…
Now it is nearly the weekend, and I don’t plan on spending it thinking about CDS, so let me leave you with one of the more interesting google hits on ‘Old R’. Can anyone tell me what a single Oerlikon is and how it might help me in a bond auction?
*That, BTW, is why US corporates trade on XR – the FED does require restructuring as a credit event to give capital relief, while European regulators do. For extra amusement, read the letter from the insurers to ISDA over Xerox. It is in appendix one of this document, the choice sentence being ‘The current definition of Restructuring is clearly not workable if it is susceptible to the misinterpretation, as it apparently is in the minds of certain market participants, that there has been a Credit Event with respect to Xerox.’
Try playing So, what would your plan for Greece be?; it’s fun and insightful.
I got 52 the first time around, 5 the second. Interestingly reading the comments, those, 53, and 10 seem to be the most popular answers, with the full Argentina leading. My favourite comment though was the suggestion that the game should be called Dungeons and Draghi…
The last post, BTW, was no. 1,500. Thank you wordpress for your sterling service over one and a half thousand posts.
Now to substantive if not entirely serious matters. You see, I was musing given all the furore over Moody’s placing us on negative outlook, shouldn’t we really teach them not to mess with sovereigns? We have those men in Hereford who work for the government, so surely some gentle persuasion can be applied…
Seriously though, does anyone really feel comfortable with the power the agencies still have, despite their manifest failings? As Claire Hill puts it, the history of rating agency reform has not been inspiring. Perhaps it is time to have another go.
I am out of town so this will be brief, but there are a lot of good things around today:
All the other factors now driving the crisis speak against holding sovereign debt in banking books as well, increasingly. No?
They are of course right about that. But if the TB/BB boundary is flexible, in other words you can just move sovereign bonds that you had in the TB into the BB with no impact on strategy and a big saving on capital, why wouldn’t you. A great question in this context is where is sovereign bond repo booked: TB or BB.
This picture is from Pictet (via the ever helpful FT alphaville):
Alphaville’s question is, given this, was Union sensible? I think it clearly was; on a weighted average spread basis, the EZ countries are still doing better than they were prior to the Euro, and even if they weren’t, those eight or nine years of low spreads were worth having (or at least they would have been if the money had been spent sensibly). In any event, what interests me more is why spreads were so low for so long. It seems to me that there are three (not necessarily mutually exclusive) possibilities:
I’m not sure where I come out on this yet…
Reports that Germany and France have begun talks to break up the eurozone amid fears that Italy will be too big to rescue
If this happens, it will make the aftermath of Lehman look like a day in the park. An utterly preventable disaster is now looking entirely possible. Truly our leaders have let us down.
Update. I strive not to be drawn into hysteria. As the economist says:
I hate to get this pessimistic about the situation. It feels panicky and overwrought. I can’t believe that Europe would allow so damaging an outcome as a financial collapse and break-up to occur… the window within which something could be done to prevent it is closing, and fast. I hope to be proven astoundingly wrong in my assessment, but I’m struggling to see alternative outcomes.
These folks are not known for proclaiming the end of the world on a regular basis. Neither is Brad DeLong, and he says:
I have been complaining for some time now that Reinhart and Rogoff think that the time is always 1931 and that we are always Austria–that the great fiscal crisis is about to erupt and send us [i.e. the US] lurching down toward Great Depression II.
Well, right now guess what? The time is 1931, and we are Austria.
The Federal Reserve needs to buy up every single European bond owned by every single American financial institution for cash before the increase in eurorisk leads American finance to tighten credit again and send us down into the double dip.
The Federal Reserve Needs to do so now.
A little historical perspective may be helpful. One of the first events in the Great Depression, and a major contributor to the loss of confidence, was the failure of Creditanstalt. This was a proto-investment bank, one of the largest in Austria; its collapse was unexpected – just like Lehman. So, um, yes Brad; it does look altogether too much like 1931 for comfort.
The forgive student debt movement seems to be gaining some traction. What I think is interesting about this – other than the fact that ex-students seem rather more deserving of forgiveness to me than sovereigns who have spent beyond their means – is the change in tone of the debate. Suddenly, partly thanks to the visibility of OWS, a lot seems possible. Now certainly history is littered with popular protest movements that came to nothing, but equally progressive change is unlikely without this kind of clamour. The autumn has signs of spring.
Update. I love the use of the term temporary autonomous zone for what is happening in Zuccotti Park. For more on that, including a lovely analogy from Slavoj Žižek (and a measure of utter nonsense), see here.
Mario Blejer, a former Bank of England adviser who took charge of Argentina’s central bank after the 2001 default, has been reported on Bloomberg:
Greece should default, and default big,… Germany and France will have to bear the brunt of financing efforts to help Greece and other countries that default re-start their economies, he said.
For what it is worth, he has an interesting point. If default is inevitable, then get it out of the way, and then you can start to grow again. Clearly the lower recovery you give, the more debts are extinguished, and hence the better your chances of recovering. Sadly we have moved from ‘if’ to ‘when’ so my sense is that Blejer is right; an early default would actually allow us to move on from the Euro tragedy that is unfolding. (That’s a German word, right, Eurotragik?)
Goodness, I like Charles’ comment to my previous post more than the original. Let us indeed go with the Geuro (pronounced ‘gyro’; it has got all the meaty countries in it) consisting of Austria, Estonia, Finland, Germany, Luxembourg, the Netherlands, Slovakia and Slovenia; and the Feuro (pronounced ‘furo’; the countries in it are going to take a bath) for Belgium, France, Portugal and Spain. As Charles says, if Belgium splits, then Wallonia has the Feuro while Flanders goes with the Geuro.
I’m not entirely sure I buy the line about Italy having to be out, though; or at least (sorry Charles), I don’t see the argument for excluding Italy as more persuasive than the one for excluding Spain. Indeed, the top half of Italy would perfectly naturally fit with the Geuro countries. It’s the bottom half that causes the issues…
Buried in the recent Basel Committee FAQ on the market risk framework – basically a set of answers to questions banks have asked about how to interpret the rules – we find:
Should sovereign bonds be included in the IRC charge?
The definition of specific risk in paragraph 709(iii), first sentence, is quite generic. Consequently, it does not scope out any particular securities. When an acceptable IRC model identifies sovereign bonds as subject to migration and default risk, the capital charge should be determined accordingly. Even if certain sovereign bonds are subject to a risk weight of 0% under the standardised approach (cf. paragraph 710), they cannot be considered as free of default and migration risk. Therefore, sovereign risk should be included in the scope of the incremental risk capital charge. Sovereign bonds must therefore be included in the relevant model. A general partial use of the standardised approach for sovereign bonds, ie exclusion of positions subject to a risk weight of 0% under the standardised approach from IRC, will not be granted. Accordingly, they will attract a capital charge under the IRC, except where the output of the model happens not to imply a capital charge for these positions.
Now, to interpret this you need to know that the IRC or incremental risk charge is one of the new trading book capital charges imposed under the Basel 2.5 changes, and due to come into force on both sides of the Atlantic shortly. Most if not all large banks will have IRC models for their trading books. This ‘interpretation’ from Basel will therefore ensure that sovereign risk is properly capitalized in these banks’ trading books. All this does of course is give the banks an even greater incentive to put such bonds in the banking book where they will be subject to the kinder disciplines of the IRB (where my guess is that some banks have the lowest permitted PD for sovereign exposures).
One question though – which idiot asked the Basel Committee to clarify this?
It is midsummer, there is no budget deal, the markets are quiet, and everyone is pig tired of dealing with crises. This could go badly. I’d say go to cash, but then the question is what currency – if a budget deal is done then the Swiss Franc will likely sell off fast, for instance; but if it isn’t, it is a least a safe haven. Unless the Swiss intervene to prevent further appreciation. Now would be a good time for someone to come up with a genuinely uncorrelated asset…
French Finance Minister Lagarde chosen to lead IMF. Score 0. (Deus Ex post here.)
Greece Set to Get Aid Payment as Banks, Lawmakers Fall in Line on Crisis. Score 1. (Deus Ex post here.)
Total 2/3: pass but must try harder.
Much of the financial world seems to be waiting for a Greek default. I am still with Barclays; I don’t think that it is happening, at least this year. OK, John Lipsky is a wildcard whose behaviour might turn the mildest of men into a conspiracy theorist, but this is still fundamentally about politics rather than economics. Krugman can huff and puff all he wants; self interest has rather little to do with this story.
Chrysia Freeland, meanwhile, reminds us of the positives of the European project amid the gloom: she asks what made the revolutions in Poland, Hungary and the Czech Republic succeed and suggests that the answer is Europe and the promise of membership in the European Union. Quoting some lovely phrases of Wanda Rapaczynski’s, Freeland describes the reforms that preceded membership in the European Union as a period of “sponsored transformation” and says “once the pressure of the beauty contest was off, the pace of reform slowed.” At a moment when many are questioning the value and the durability of the European experiment, Rapaczynski’s reminder of the positive power the European idea has had in the eastern half of the Continent is timely. Exactly right.
FT alphaville suggests that a consequence of the CFTC proposed rule whereby sovereigns (except the US, naturally) will have to post collateral to US swap dealers on OTC derivatives is that US swap dealers won’t do many trades with sovereigns. They are of course right. The large European, Asian and Latin American debt management offices will not post collateral at the whim of the Americans – or anyone else.
Should they (and indeed the US government) be obliged to post? Well, it depends. If they had to, they would have to find the money from somewhere, and that would increase their levels of debt. On the other hand, one way CSAs, whereby the dealers have to post collateral to the sovereign but not vice versa, are a liquidity drain on the banking system.
The clinch argument for me, though, is CVA. Uncollateralised derivatives create a big CVA. (See here or here for a description of CVA and how it arises.) Basel 3 will require banks to hedge their CVA well or take capital against it. Critically this includes CVA from sovereign transactions. The way you hedge CVA is to buy CDS. Thus when you see a picture like these two from the Alphaville post:
What should ask yourself is ‘how much of this increase in CDS trading is caused by CVA hedging?‘
The prior post suggests that there is only $4-30 Billion net notional of CDS on even the biggest countries. My guess is that the major swap dealers need a good deal more liquidity than that to hedge their collective CVA position without moving the market.
The Basel 3 CVA rules, then, are a huge shot in the foot for governments. (A 50mm shell in the foot, maybe.) By forcing banks to hedge their sovereign CVA, they have increased the demand for sovereign CDS. That drives out spreads, which in turn increases borrowing costs for governments. The problem could be largely solved if sovereigns would agree to post collateral – but they won’t.
This is data for the next post. It comprises the top twenty sovereigns by CDS net notional currently as reported to the DTCC.
|Reference||Market||Notional (USD EQ)|
… typically trade under Old R restructuring. That fact could be become rather important soon. In Old R trades there is no limit on the maturity of the deliverable obligation, and no tranching in the auction post credit event. That in turn means the cheapest to deliver option may be quite valuable – there may be quite a large spread between short and long-dated bond prices post restructuring. Thus going into the event you can expect the CDS spread/bond spread relationship to be interesting. Everyone who entered into negative basis trades on Greece knew all this, right?
Update. Here are a few more links: more on negative basis trades on Greece and Barcap’s thoughts on how Greece will go (a soft restructuring which does not trigger CDS followed by a hard one a little while later that does).
Why rob a bank?
Because that is where the money is.
That’s Sutton’s law, and a lot of sense it makes too. So, if you are a sovereign without enough money, who do you go to? Someone with money.
This means that there are only a limited number of choices for solving the endebtedness problem in advanced nations. Your choices are one or more of:
The last won’t work for ever; you can’t keep increasing your borrowing as a percentage of GDP. Sovereign default or restructuring works, but it stops you from being able to borrow again for some time. Thus central bankers often think that you have to bear most of the burden internally. That makes it a pain allocation problem. Increase taxes; decrease services: these things are unpopular.
Reinhart and Sbrancia point out an interesting mechanism that allows governments to give some of the pain to bond holders without the stigma of a hard restructuring. From their abstract:
A subtle type of debt restructuring takes the form of “financial
repression.” Financial repression includes directed lending to government by captive domestic audiences (such as pension funds), explicit or implicit caps on interest rates, regulation of cross-border capital movements, and (generally) a tighter connection between government and banks… Low nominal interest rates help reduce debt servicing costs while a high incidence of negative real interest rates liquidates or erodes the real value of government debt. Thus, financial repression is most successful in liquidating debts when accompanied by a steady dose of inflation.
Think of this as a subtle form of taxation. By providing negative real returns, governments can slowly take money from bond holders. Of course solving a government endebtedness problem this way also requires spending to grow less slowly than inflation, which is difficult. But it does provide a mechanism which many advanced nations will find attractive. The Bond Vigilantes don’t think we are there yet. But I suspect that we will be in due course.
There is a story that Equador rather cleverly bought their bonds back in the secondary market after default rather than waiting for the restructuring. Essentially instead of having to pay 35 cents on the dollar, they paid in the 20s, and so saved the country a few hundred million dollars. Apparently the State Department thinks that this is market manipulation. Well, frankly, screw them and anyone who thinks like them.
Equador has GDP per capita of of $8,000 comfortably putting it outside the top 100 countries in the world by income per head. 33% of the population is below the poverty line. (Figures from the CIA.) It is only keeping its head above water thanks to the high oil price. If a country like this can extract a few hundred million out of emerging market bond holders through some smart trading then my view is good luck to them.
The auction results are out on the Anglo Irish credit event. Roughly: sub recovery 18%; senior 75%.
The sub is clearly about right. The senior, though, is interesting. Would you rather have 75% for sure now or run the risk of getting 50% or less later in some Irish restructuring? On the other hand, if you think that the rescue will work, then a 25% haircut on the senior is penal.
European countries should reduce the principal amount they owe by issuing gross domestic product-linked sovereign bonds as an incentive to creditors to take a haircut on the debt. Bondholders would accept, say, 70 cents on the dollar on their bonds and receive new debt paying the German bund rate and with a warrant that pays a coupon tied to the amount each country’s respective GDP exceeds, say, 2 percent. The warrants could have an assigned value at inception — based on a long-term call option on GDP — and be detachable and traded separately.
This is like a debt-for-converts swap. Existing bond holders are offered new bonds plus the warrants. If the warrants are long dated enough, you can reduce the principal sufficiently that the burden of payment drops signifcantly. A 30% haircut, as Brian suggests, is perfectly possible.
The problem, though, is that the warrants would be really attractive to hedge funds only if they were hedgeable, and you can’t short GDP easily. I wonder if inflation is a reasonable proxy. If instead the warrants paid out based on ten year cumulative inflation, then dealers could hedged using inflation-linked bonds, and the effect might be similar. This would also likely have the desirable side effect of making the linker market more liquid and hence decreasing linker issuer costs for governments. (I have not had time to look at inflation volatility and price up the option, but given the forward inflation curve is quite steep I imagine the maths could be made to work.)
Update. I couldn’t resist pricing up the warrant (which in itself wasn’t easy – you have to think hard about the replicating portfolio to get the right answer), and with a plausible HICP vol a 2% strike 10 year inflation warrant does indeed come out as being worth 30%. So the trade described above passes at least the first sanity check…
There were four horsemen, right? Well, the third has just cantered into the yard and asked if someone can sharpen his scythe. From LCH:
In accordance with the Sovereign Risk Framework issued on 5 October 2010, and in response to the yield differential of 10 year Irish government debt against a AAA benchmark, LCH.Clearnet Ltd has revised the risk parameters for Irish government bonds cleared through the RepoClear service. The margin required for positions of Irish government bonds will consequently be an additional 45% of net positions over the standard margin rate.
A careless journalist says:
If you’re a bank and the country you’re based in goes bust, then you’re going to go bust too.
Nope. Or, more precisely, if a sovereign defaults on foreign currency debt, then banks incorporated in that country do not have to default on their foreign currency debt too, and even more importantly they certainly don’t have to default on their local currency debt. If banks only have local currency debt, they may well be fine – especially if they have foreign currency assets which will likely appreciate vs. their debt, and if the central bank makes lots of liquidity available in local currency, which it might.
If the banks have foreign currency debt too, their default depends on their ability to service it (given any government action): if they have foreign currency assets too, and not too much funding liquidity risk, they might survive.
For all of these reasons, by the way, there is a case for some banks with substantial foreign asset bases to be rated through their sovereign of incorporation.
As was always very highly likely, Greek default has been averted. You might add ‘for now’, and certainly the omens are not entirely good. However in looking at the PIIGS one must understand the context: the Euro project, as we have previously commented, is not primarily an economic one. It is political. This means that things will be done which are perhaps not rational economically. If you bet against Greece, you are not betting on the Greeks failing to sort out their problems. You are betting against the rest of the Eurozone, and Germany in particular, not supporting them. Despite Germany becoming more selfish recently, this seems unlikely: a lot more unlikely than the markets are estimating, anyway. I still like selling first to default protection on the PIIGS: if Citigroup and JPMorgan are too big to fail, how much more so are Greece, Portugal, Ireland, Spain and Italy? The Eurozone may seem disorganised, slow to react, and sclerotic. It might have labour markets which frighten economists, pensions deficits going to the sky, and low growth. But it is one of the richest areas in the world, and it will remain such. It can afford to rescue its members, and my guess is that if push comes to shove, that is what will happen.
As I expected, given the primarily political rather than economic character of the Euro project, Greek has been propped up.
This is both rational on a standalone basis, and as a signal to the markets. If Greece had defaulted, the pressure would have been huge on the rest of the the PIIGS. Sell one year first to default protection on Portugal, Ireland, Italy and Spain before the spreads come in too much.
John Kemp thinks that Greece should default and reschedule. I wonder.
The idea has immediate appeal from the point of view of punishing imprudent lenders. But, attractive though that is, would it be the best thing for the Greek people? It rather depends on whether the incremental cost of raising money post default is larger than the savings available through defaulting. There is no reason so far as I am aware that Greece could not default and still stay in the Eurozone. But obviously if they were to go for the nuclear option, then the spreads of Italy and Portugal would go out hugely – probably Spain too. And a lot of rather unsavoury people would make a lot of money.
I doubt very much whether this will happen, even if it is rational. But I have been wrong about Greece before…
Evidently not. From the FT:
Greek stocks and bond markets surged on Monday as investors flooded the government with demand for its first bond offering of the year… The coupon interest payment on the deal, expected to be worth €5bn, is likely to be 6.12 per cent – or 3.8 percentage points higher than equivalent German bonds. This is a record spread and underlines the premium Greece must pay over Germany, the benchmark market in the eurozone, for its financial troubles.
For Greece that is one challenge negotiated, at least. Fixed income investors are still hungry for yield, and Eurozone government risk at 380 over bunds is evidently attractive. High(er) yield issuers everywhere take note – if you are even somewhat generous, you can currently get long-dated deals done at yields that are in absolute terms delightfully low.
The markets are all over the place today. That spells opportunity. For me the glaringly good one is Greek sovereign CDS: as Ibex Salad pointed out in a comment on my previous post on spread widening, from a fundamental perspective, this looks like money for old rope. Yes, spreads could widen further, so don’t buy a product with a spread trigger, but otherwise selling protection on Greece for over 200 running looks like a no brainer.
Here’s the spread history, courtesy of FT alphaville:
If you have even stronger nerves, consider a short in gold (ideally priced in Euros or Yen…)
FT alphaville picks up some research from Paribas on sovereign CDS spreads. The claim is that spread widening in the peripheral EU countries are being driven by ECB policy:
Certainly ECB action could cause a weakening in demand for certain government bonds as the ability to finance them cheaply and earn carry disappears. Spreads are definitely widening, as the illustration shows.
(This story would be a little more compelling if we could see the historical spreads for Greece, Poland, Slovakia etc., but it is safe to assume that these have blown out too.)
Is this all ECB driven?
I suspect not. In particular there is a popular credit derivatives product which packages up a leveraged sovereign CDS in a note. Essentially the buyer of the note gets an enhanced return in exchange for selling CDS on a multiple of their notional at risk. The catch with these products is that they do not just trigger on an ordinary credit event: in order to protect the selling bank, they also trigger on spread widening.
Thus for instance on popular version of the product in 2008 year paid Libor plus 1% or so in exchange for seven times leveraged exposure on Spain, with a trigger if the Spanish sovereign CDS spread hit 100 – a level it is perilously close to today.
These notes are reasonably subtle products in that they can seem to the naive like simple speculations on sovereign default – and no one expects Spain to default. But the spread trigger means that they are in fact rather sophisticated forms of credit spread option. The note issuers hedge by selling sovereign CDS on the other side. All else being equal, this should act as a brake on spread widening, as note buyers take advantage of better spreads to sell more CDS.
But who are the buyers of sovereign CDS on the other side of this and other trades? There is much less pressure to do negative basis trades on government bonds as there is little regulatory capital advantage. So what puzzles me about the spread action is who is paying these high prices to buy sovereign protection, especially on the better quality names. That is the real answer to the spread widening puzzle.