Euro Area Credit Market Charts

Further below is our customary collection of CDS prices, bond yields, euro basis swaps and several other charts. Both charts and price scales are color coded (readers should keep the different scales in mind when assessing 4-in-1 charts). Prices are as of Friday's close.

Friday saw some improvement in Spain's bond yields, and a slight rise in Italy's. These are currently probably the most important government bond yields in the world. CDS on Spain and Italy have come in a bit as well, but at 419 and 542 basis points respectively remain uncomfortably elevated.  Yields on the  bonds of the euro area's 'AAA club' generally improved strongly last week, in spite of the rising probability of ratings downgrades (see Austrian yields below as an example, French 10 year yields also declined by about 30 basis points last week). Euro basis swaps improved strongly.

We note that the EU's ban on 'naked' CDS trading has had exactly zero effect on CDS prices – in other words, the ban has predictably failed to bring about the desired result. It may well have exacerbated selling in sovereign bonds however, as those can still be shorted – which a few fund managers appear to have indeed done.


Greece & David Einhorn

The IMF's recent negative assessment of Greece's progress in meeting its fiscal targets has not gone unnoticed in the markets. 5 year CDS on Greece trade now at an incredible 14,395 basis points. We have never seen anything like this. It costs now nearly 44% more to insure Greek government debt against default than the face value of said debt amounts to. In other words, it implies a negative recovery, which is theoretically impossible. This may appear to make no sense until one considers that e.g. the yield on the one year note currently stands at around 330%. So for a buyer of the one year note it still makes sense to pay up for insurance to at least limit potential losses in case of a hard default , or putting it differently,  this trade amounts to an arbitrage of negative basis (we can't come up with a better explanation at this point – if someone can, please enlighten us. We know that sometimes CDS involving special bilateral agreements w.r.t. upfront payments trade above 10,000 bips). This arbitrage is not without risk, as coupons are usually paid semi-annually, while payments on CDS must be made quarterly.

As far as the implied default probability goes, try: 'double-plus-100%-certain'. Back in June, when CDS on Greece rose to a 'mere' 3,045 basis points, a World Bank report on Greece indicated that this implied a 91% default probability.

Among notable recent events surrounding Greek debt, David Einhorn's Greenlight Funds have cashed out of many sovereign CDS holdings following the decision to make the Greek debt exchange a 'voluntary' event, which appeared specifically designed to protect various CDS writing banks from having to pay up, while keeping up the charade that euro are nations simply don't default.

However, Einhorn evidently remains quite convinced that Greece will eventually default, since he has shorted its bonds instead. This trade has the added advantage of removing the counterparty risk of CDS writers. 

As Bloomberg reports, quoting from a (slightly dated) Einhorn letter to investors in the  Greenlight fund:


Greenlight revealed some of its thinking in a July 7 investor letter that cites “The Treachery of Images,” a painting by the Belgian surrealist René Magritte, in discussing European efforts to avoid a Greek debt default.

The letter touched on two risks tied to credit swaps on European sovereign debt, including regulators’ attempts to fashion a Greek bailout in a way that prevented the contracts from paying out. The second risk was the possibility that banks that wrote billions of dollars in credit swaps on sovereign debt might not be able to make good on their obligations should a country such as Greece actually default.

Greenlight, citing French President Nicolas Sarkozy in particular, noted that regulators were determined to prevent the Greek bailout from being classified as a “credit event,” which would trigger a payout to swap holders. Stating that “it is very odd to hear a political leader use such technical jargon,” Greenlight then asks in the letter “Why would Mr. Sarkozy do this?”

The letter raises the possibility that French banks have “enormous exposure” to sovereign-credit events. That’s because banking regulations define sovereign credits as risk free, allowing banks to take on as much sovereign-credit risk as they wanted, perhaps by issuing credit swaps, without having to set aside any capital.

“Under such a structure, selling short CDS protection is akin to free money for the banks,” Greenlight says in the letter. “No one knows just how much aggregate exposure to sovereign debt and CDS is hidden in the banking system, and no one is itching to find out.”

In late October, the European Union reached an agreement where banks would write down their holdings of Greek bonds by 50 percent. The International Swaps and Derivatives Association’s chief lawyer said because the deal is considered voluntary, it won’t require firms that sold credit protection on Greece to pay buyers of the swaps.

In describing the potential for this sort of outcome back in July, Greenlight recalled that Magritte’s pipe painting includes a caption that translates to “This is not a pipe.” Magritte proved the image was not a pipe by telling doubters, ‘Just try to fill it with tobacco’.

“As Magritte might say, ‘This is not a default’,” Greenlight wrote. “Just try to collect on your credit default swaps.”

 

(emphasis added)

 


 

The Treachery of Images

Try to fill it with tobacco and you'll notice it is not a pipe – it is just an image.

(Painting by René Magritte)

 


 

Considering the Magrittian nature of CDS on Greece, someone sure seems to think that in spite of all the contortions, these contracts will pay out.

 


 

5 year CDS on Portugal, Italy, Greece and Spain. At 14,395 basis points, Greece is setting records once again – click chart for better resolution.

 


 

5 year CDS on France, Belgium, Ireland and Japan – click chart for better resolution.

 


 

5 year CDS on Bulgaria, Hungary, Croatia and Austria – click chart for better resolution.

 


 

5 year CDS on Latvia, Lithuania, Slovenia and Slovakia – click chart for better resolution.

 


 

5 year CDS on Romania, Poland,  Lithuania and Estonia – click chart for better resolution.

 


 

5 year CDS on Bahrain, Saudi Arabia, Morocco and Turkey – click chart for better resolution.

 


 

Three month, one year, three year and five year euro basis swaps -  there was a big bounce in those, and it is probably no coincidence that gold rallied concurrently – click chart for better resolution.

 


 

Our proprietary unweighted index of 5 year CDS on eight major European banks (BBVA, Banca Monte dei Paschi di Siena, Societe Generale, BNP Paribas, Deutsche Bank, UBS, Intesa Sanpaolo and Unicredito) – pulling back a little. This index tends to move in the opposite direction of the euro basis swaps most of the time; in that sense  we note that there was recently a notable divergence, in that the index failed to reach its previous high even though euro basis swaps revisited their earlier extreme – click chart for better resolution.

 


 

5 year CDS on two Austrian banks (Erstebank and Raiffeisen), indexed – to get the value in basis points divide the index values by the divisors in the legend. These banks are greatly exposed to the CEE region and have received a painful blow from Viktor Orban's government in Hungary, which unilaterally re-denominated CHF mortages into forint – click chart for better resolution.

 


 

10 year government bond yields of Italy, Greece, Portugal and Spain – Spain's yields are trending down, Italy's can only be said to have dipped slightly (in fact, on Friday they bounced again, if only by 2 basis points) – click chart for better resolution.

 


 

10 year government bond yield of Austria, the 9 year government bond yield of Ireland, UK Gilts and the Greek 2 year note.  A new low in gilt yields and both Austrian and Irish yields keep improving, the former noticeably so – click chart for better resolution.

 


 

5 year CDS on the debt of Australia's 'Big Four' banks – a small dip – click chart for better resolution.

 


 

The ECB's balance sheet. For those who may have missed this chart last week: the size of the ECB's balance sheet as of last week in € billion. Since the low point in April (incidentally this was around the time Western stock markets topped out), some €500 billion have been added, growing the balance sheet by more than 25% – click chart for better resolution.

 


 

Nevertheless, true money supply growth stood at only 1.8% year-on-year at the end of October, whereby currency in circulation grew by 6.5% and sight deposits by a mere 0.8%. This is – so far – in stark contrast to the big post 2008 crisis jump in money supply growth. Note however in this context that there was a notable lag between ECB balance sheet expansion (which began in late 2007) to the jump in money supply growth back then, and we can not yet judge the effect the most recently announced easing measures will have on money supply growth.

 

ISDA discusses Euro Breakup

It sure looks like no-one is believing the spin-meisters in Brussels anymore. The latest agency to give some thought to the consequences of a euro breakup is ISDA (International Swaps and Derivatives Association), the same pliable organization that has decided to follow the eurocracy's reasoning on the Greek 'non-credit event' that somehow stipulates that creditors can lose 50% of their investment while they can simultaneously take their hedges and use them as wall-paper (and Greece is not even happy with 50%, but wants to reduce the net present value of the new bonds further by offering a lower coupon, effectively demanding a 75% haircut).


Still, it seems to have dawned on ISDA's members that trusting the promises that emerge from various emergency summits in the euro area may turn out to be a mug's game. This is a reasonable assessment – it is better to be prepared and sorry than to be not prepared and be really sorry.


As the WSJ reports:




“Professionals in the $708 trillion global swaps market have been pondering how their contracts could be affected by a partial or full dissolution of the euro, prompting the industry's trade body to start advising swap users how to plan for such potential scenarios.

The International Swaps and Derivatives Association sent a memo to members Thursday saying it will hold a webcast next week to discuss "what would happen to euro-denominated derivatives contracts if one or more countries were to leave the euro-zone and establish an alternative currency."

In the memo, seen by Dow Jones Newswires, the association said it believed a euro breakup was unlikely but added it had been contacted by many of its members who are "already making contingency plans" and have been "instructed by their supervisors to report on their preparations." Members have asked ISDA to pay a role in their planning.  The trade body, which plays a crucial role in determining market standards for swap contracts, didn't respond to requests for comment Friday.

But in the memo, the association said it had been consulting with its counsel "for some time" to contemplate the implications of a possible euro breakup, and how the swaps industry could prepare.  ISDA's webcast will be held on Dec. 21 at 3pm London time, and is closed to the press and non-members of the association.

One possible response to a euro-zone exit is to have an industry protocol that would switch swaps, those that either require payment in the common currency or delivery of euros, to one or more new currencies, lawyers said Friday. ISDA used such a protocol in 1998 to convert swaps requiring payment in legacy currencies, or referencing them to the euro at fixed conversion rates.

"Protocols are an efficient way to agree large numbers of contracts with several people very quickly," said Matthew Magidson, chair of the derivatives practice at Lowenstein Sandler.  "I'd imagine there very well could be a market protocol so there is an orderly and agreed-upon way to deal with a potential disappearance of the euro," said another lawyer.

One of the biggest challenges is preparing for a possible event that could happen in so many different ways, with varying outcomes. A third lawyer said the protocol for transitioning swap contracts to the euro was devised several months after politicians had decided on a plan to bring about the euro, whereas in this case there is no such plan.

It's not clear if there could be one or more individual sovereigns looking to exit, or a wholesale breakup eliminating the euro entirely, or even a north-south divide in Europe's usage of the common currency.

Nor is it clear whether any exit would be orderly and consensually agreed upon under a treaty, or unilaterally decided by the departing member. The U.K. opted out of the euro currency, for example, but is still part of the European Union, and committed to certain movement of people, goods and capital among member states.

With so much uncertainty, the industry can only brainstorm what the possible issues could be, lawyers said. Chief among these is how contracts would be affected by their governing jurisdictions–most falling under U.K. or New York law–and whether payments could be made in any new currency if a party to a trade was domiciled in a departing member state.”


Sounds like it will be an interesting discussion -  transitioning to a new state of affairs for which 'there is no plan'.

 

Voting One's Book

In other news, some holders of CDS have just alleged that the ISDA committee that decides on what constitutes a credit event is riddled with bias, i.e. they claim it is voting its own book. This happened in connection with the recent keeling over of SEAT Pagine Gialle, an Italian company. Greece merits a mention as well. 

According to Bloomberg:


“Senior credit traders have heavily criticised the committee that rules on credit default swap triggers, accusing rival firms of voting based on their trading positions rather than on legal merits.

The International Swaps and Derivatives Association strongly rejected the allegations, which stem from a split vote concerning whether or not a credit event had occurred with respect to Italian firm SEAT Pagine Gialle on November 28. But the derivatives trade body admitted it was in the process of bolstering standards to ensure dealers cannot "vote their books".

The critical remarks will come as blow to ISDA's EMEA Credit Derivatives Determination Committee, whose members usually close ranks and staunchly defend the process for deciding CDS triggers in the face of media scrutiny. The criticism may also heighten concerns about a market already in a state of flux, with participants questioning the value of the instrument if Greek CDS does not trigger.”

"The SEAT vote didn't seem very independent in the way people were voting on legal merit versus their position," said one senior credit trader, whose firm sits on the DC. "How to enforce independent decision-making may not have been carefully thought out when the DC was set up. It's a concern that won't go away and will eventually come up in the context of Greece."

All participants agreed that the SEAT case was legally complex. The Italian firm's bonds were issued by a Luxembourg-based special-purpose vehicle, which had a loan agreement with SEAT. When a payment was missed, there was debate over whether the grace period of the bonds – 30 days – should be applied to the loan (which would have otherwise have had a three-day grace period).

The DC reached a deadlock of eight votes to seven, and the decision was sent for external review. This subsequently proved unnecessary: two days later the 30-day grace period expired and a credit event was agreed upon unanimously.

Despite the eventual CDS trigger, two firms with DC representation told IFR they were frustrated by the original decision and remained suspicious of other members' voting motives.


In times when liquidity is tight, it is to be expected that such disputes will become more frequent, even if this one was in the end resolved to everyone's satisfaction.

In this particular case, Magritte would probably remind us that 'this is not a fountain'.

 


 

Ceci n'est pas une fontaine

it isn't even the picture of one! What you see here could be termed the

'treachery of upside-down urinals'.

(Painting by René Magritte)

 


 

Addendum :

  

A Few Papers on CDS For Download

For readers interested in the details of how CDS actually work, here is an extensive backgrounder from JP Morgan for download (pdf).

In addition, here is a somewhat more technical research paper that goes a bot further into the maths of calculating the value of CDS, default probabilities, etc.  (pdf)

Lastly a paper on using fundamental analysis to explain variations in CDS prices and how such analysis can potentially be used to predict future moves in CDS spreads (pdf).



 

Greece's one year note yield as at the end of last week: at 328.7% it likely invites arbitrage with CDS on Greek debt.


 


 

 

 

Charts by: Bloomberg


 

 

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7 Responses to “Ceci N’est Pas Une Pipe – And It Ain’t A Fountain Either”

  • Much appreciation Pater for a blow by blow account of one of the great financial events in history, no matter how it ends. I was thinking how precarious a position Greenlight would find themselves if somehow the bonds they were short actually paid out. We are clearly a discount to a 50 cent haircut, as 300% would be about 25 cents on the dollar. Never doubt the treachery of those involved in these markets, as we have seen with the Goldman bailout by the NY Fed using government funds to pay AIG losses.

    I can’t see how the markets can stand up much longer. We have a politicization of the derivatives market in CDS’s, enabling one group to collect premiums for options they never have to pay, thus creating a one sided contract. Then we have the hypothecation game going on and no telling how much front running news in the over night markets. This all follows a decade of packaging junk debt and providing a model built on fiction to get it rated AAA. The pay of those working for Goldman approaches the annual budget for the State of Texas. Clearly this isn’t all money made from honest markets. When does the world lose faith in such a carnival shell game?

    • Indeed, it is no exaggeration to say that this is a shell game – the entire monetary system reminds me of a Three Card Monte game in fact. How long the faith in the functioning of this system remains in place is unknowable – but one should not underestimate the ability of the authorities to keep it going. After all, even the Soviet system survived for over seven decades, in spite of not even being able to calculate (or only able to calculate in a very rudimentary manner by observing market prices in the capitalist system).

  • MisterB:

    This is an educated guess only. Is not the CDS based on the Face Amount of the bond? On the other hand the bonds are selling for way less than the Face Amount.
    In round numbers a $100 dollar bond selling for $25 would give one a $75 return or 300% if it were to be paid. If one purchased 4 bonds for $100 there would be $400 received if the bond were actually to be paid. If one purchased a CDS for $150 one would receive $100 if there were a default. Therefore, one would gain a net $150 if the bonds paid but only lose a net $50 if defaulted. If the bonds were to pay out at the 50% rate then the net gain would be $50 ($200 less the $150 CDS cost). The net default cost would be still be $50.

    • Mr. B. I think your math is fairly close. It is clear that a bond discounted to return 300% would be worth about 25 cents. Thus you could put $1 million into these bonds and buy $4 million face. To insure your million, you would put up $1.435 million, but it would be payable quarterly or about $360K per quarter. I don’t know what the coupon on the Greek bonds would be, but they might not over 5%, so you would only get $100K semi annually. IF it all blew up after half a year, it appears you would have $1.7175 million up and you would get back $1 million for a downside of $717,500. The upside would be the $4 million minus the cost of the bonds and the swap or about $2.565 million. It looks like a risky proposition no matter how it is sliced.

      • mc:

        The CDS prices and payouts are all based on the nominal contract value. Buy $4M face value for $1M and a CDS would mean 144% annualized CDS payments at $1.44M every quarter (nearly $6M per year). However, you would collect $4M if the CDS paid (dubious if Sarkozy and the French banks have their way), meaning you would about break even if Greece defaults in 6 months (collect $4M and pay $3.88M), and the CDS writer would break even if Greece could recover 3% ($0.12M) after 6mo.

        Crazy risky, yes, but CDS prices get ridiculous as default probabilities approach 100%.

  • Monty Capuletti:

    Pater,

    The only other explanation I could think of on how CDS could reasonably be priced at those levels was if prices were embedding both default and euro exit, leading to redenomination in drachma, which would be paid out currency. My understanding is that the 90% of Greek debt issued under Greek Law provides under certain cicrumstances under “local” currency, which would effectively mean holders of Euro-denominated Greek debt under a sovereign default could be repaid in Drachma-Denominated Greek debt, implying the FX loss under that scenario is being priced into CDS in addition to a nominal default. Just a thought..

    • That seems certainly possible, as a hard default would likely lead to an exit of Greece from the euro in short order. But it seems to me the ‘arbitrage’ assumption also works. In the meantime, CDS on Greece have fallen back below 9,000 basis points – they remain extremely volatile.

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