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Credit Default Swap Spreads/ Why Does the Market Think A Crisis Might Occur

CDS spreads have always been a central part of any discussions on the imminence, probability, and magnitude of a debt crisis. This one is no different. CDS contracts act essentially as insurance on debt, and when they rise, the market is indicating that it believes a debt crisis is becoming more likely. James Bullard, the St. Louis Fed President, cited the fact that CDS spreads have not reached the levels experienced during the Lehman crisis as evidence of the relatively low danger of the current crisis. European senior finance debt CDS, which is a broad measure of CDS spreads across the European finance sector, reached its all time high in March 2009 of 207 basis points, but recently this CDS spread had climbed to 165 basis points. For more information on recent CDS trends and a historical graph, go here.

European Union-based bank CDS spreads, trading at less than 100 basis points two short months ago, are now trading around 200 basis points, which is the highest level since the Lehman Brothers crisis. As banks across Europe, specifically Germany and France, continue releasing data on their exposure to Greek sovereign debt, fears about contagion effects are raising the prices for CDS to hedge exposure to their losses. For instance,

“Widening bank CDS spreads have helped drive the Markit iTraxx Senior Financials credit default swap index to a level that is about 56.5 basis points wider than the broader iTraxx Europe index, according to Markit. This is a record wide spread, and compares with a spread of about 10 basis points just after Lehman Brothers filed for bankruptcy in September 2008. In normal times, there is a big spread differential in favour of the financial index. “This is not a normal situation. The banks are loaded with Greek risk, and this contagion effect is much stronger on the banking side than on the non-financial corporate side,” said Jochen Felsenheimer, a fund manager at Assenagon Asset Management. Banks and insurers bought government debt in the credit crisis and its aftermath, which is now making them vulnerable to widening sovereign credit spreads. Investors, including insurers and banks, also increased exposure to banks in the bond and CDS markets to take advantage of rapidly narrowing spreads in the recovery. They are now hedging those positions by selling financial bonds or buying protection in the CDS market, pushing spreads of financial credits wider, Felsenheimer said.”

So far, the European governments have acted ineptly in trying to lower CDS spreads:

“The increase [in prices for CDS spreads] has come despite the German government on Tuesday imposing a ban on the naked short-selling of German banking shares and EU government debt, including a bar on naked transactions in CDS, whereby a trader buys CDS on a bond they don’t own purely to take a directional view on the company or country’s credit. Simon Ballard, a senior credit strategist at RBC Capital Markets, said: “Banning short-selling of sovereign CDS and certain other instruments may help to reduce speculative flows in the short-term and gain some political advantage, but the key problem underlying all this is investors’ lack of conviction in sovereign debt. And banning short-selling does nothing to address that issue.”

The cost of five-year protection on Greek sovereign debt, by itself, stands close to an astronomical 700 basis points. Before going further in my analysis of CDS spreads, I should mention that there are significant facets of the CDS market that may hinder its usefulness. This guy using three excellent graphs comparing CDS spreads and bond yields demonstrates “CDS were not the driver of risk up or down but held their somewhat barometer-like relationship to cash quite healthily.” Credit Lime, which specializes in Credit Default Swap markets, summarized the previous study writing:

“The graphs all seem to indicate the following point about the relationship (or lack of one) between Greece’s bonds and CDS, namely that it is not clearly evident from observed prices and yields that you can definitely say CDS is responsible for a financial crisis since in some cases bond yields keep rising (bond prices keep falling) while CDS prices have settled down and are actually falling.”

This Reuters article presents another two possible flaws:

“Swaps are also swayed by market factors including liquidity and risk aversion. “CDS are not based on observables, but are a function of momentum,” said Christopher Whalen, managing director at Institutional Risk Analytics. A comparison of defaults implied by CDS levels with that of Kamakura, which produces default probability ratings for around 27,000 firms, shows that some of the largest diversions between the two default probabilities are on the riskiest large banks….

CDS spreads overstate the credit risk of a firm… Defaults implied by CDSs can overstate actual failures as sellers of protection will typically require a premium for taking on the risk, especially when a company becomes distressed.”

Another possible problem with placing too much emphasis on CDS spreads is that they are relatively low-quantity trading in comparison to stock markets. Despite all these issues that suggest CDS has not been an accurate gauge of default risk in the past, they have been proven spot on recently. Gregory Zuckerman of the WSJ has more:

“…CDS prices have moved in lockstep with bond prices of the nation’s debt over the last six months in places like Greece, suggesting that the CDS contracts aren’t much more volatile than other investments.”

So why have CDS spreads been rising lately?

First of all, the economies of Europe are very connected as explained in this blog’s first section and there are growing fears that a Greek debt crisis may spill over to other members of the European Union. The exposure of European banks to Greek debt and the other PIIGS hardly creates market confidence.

Additionally, Greece historically defaults on its debt like it’s a national pastime. Remarkably, since its independence in 1832, Greece has spent more time in default than not. Perhaps for this reason, Greece is not very politically trusted by the market as explained here:

“The EU/IMF bailout package is dependent on Greece implementing harsh austerity measures, measures that are (rather predictably) unpopular with citizens.  Greeks have demonstrated their displeasure through a number of protests–some resulting in violence.  Any sort of fiscal restraint and budgetary austerity comes down to politics–will the government have the political will to endure the serious protests of their constituents.  The price of insurance for banks with heavy exposure to Greece is signaling that the market thinks the political risk here is significant and likely to lead to default.”

Some analysts are concerned that the planned bailout of Greek debt may simply create a deeper recession.  Kevin Hassett from Bloomberg writes:

“As part of the bailout, Greece is required to take tough medicine to get its fiscal house in order, such as cutting salaries and pensions of government workers. That’s easier said than done, given Greece’s long history of generously rewarding those who go to work. But the story doesn’t end here. The fatal flaw in the plan is that the European nations bailing out Greece — even Germany, where government debt has risen to about 80 percent of gross domestic product — have similar budget problems and even less political will to take similar medicine. Their plan appears to rest on the hope that lenders won’t notice. Eventually they will, and when that happens, a worldwide loss of faith in government debt markets is a virtual certainty. In other words, it is hardly good news for a creditor if a hopelessly bankrupt borrower offers to take on the debts of a hopelessly bankrupt borrower…

The only thing that has to happen is that lenders notice that the Europeans who plan to borrow money to repay entities that hold Greek debt are hardly better credit risks than the Greeks themselves. It might start with a failed Greek government debt auction, but it could rapidly affect every Western government trying to borrow funds.”

Others worry that the bailout package contains too many addendums, here:

“The €750 billion bailout package announced two weeks ago by EU governments is being hedged about with so many conditions and qualifications that it resembles the original $700 billion Bush bailout plan. The 16 bickering leaders of the eurozone seem to be emulating the confusion of the US political establishment and multiplying it by 16.”

It seems that so far the Greek aid package has proven unpopular in the market, see here:

“Markets have given a clear ‘thumbs down’ to the Greek aid package,” said Win Thin, senior currency analyst at Brown Brothers Harriman & Co. They “are telling us that the aid package has not lessened default risk by any significant amount.” “Remember, the entire Greek aid package is predicated on getting market borrowing rates back down so that Greece can issue new debt for the private sector and stay current on its current debt load,” Thin said in a note. “That’s not happening yet.”

Part of the unpopularity arises from fears that Greece may still need to restructure its debt even after the bailout package. Perhaps the strongest reason CDS prices are still rising is the underlying problem of Greece, and the other PIIGS, is utter non-competitiveness, which is a long-term problem unfixable by any short-term solutions.  For instance, “Consider the World Bank’s Doing Business index, which ranks countries according to the quality of their regulatory environment for commerce. The index places Greece at No. 109, just behind Egypt, Ethiopia and Lebanon…” The problem becomes greater for Greece because as the German and French economies continue growing, devaluing Greek wages and prices becomes more necessary.