Thursday, December 1, 2011

European Debt Credit Default Swaps - The Next Crisis?

With this week's news that central banks around the world are intervening to prevent the world's fiscal house of cards from imploding, I thought that it was a good time to take a look at the latest speech given by James Bullard, President and CEO of the Federal Reserve Bank of St. Louis.   His speech entitled "The United States Macroeconomic Situation and Monetary Policy" was given to the CFA Society of St. Louis on November 15, 2011.  I'm going to tie part of his speech into the United States banking system as it is connected to Europe's debt crisis after I take a very brief look at his introductory comments and slides.

I'm going to open this posting with a screen capture of the first slide from his presentation:

Note that the Federal Open Market Committee is warning about "substantial downside risks", mostly emanating from Europe.  This is more than a bit offputting coming from a central banker in a nation who is currently running a $15.1 trillion debt but apparently, that's neither here nor there.  On the upside, apparently, the St. Louis FRB feels that we no longer have to worry about a United States recession despite bad, bad debt behaviour by Europe!  Despite that, the Fed has downgraded real growth in GDP substantially over a one month period as shown on this graph comparing the June and July data:

Sorry for the momentary diversion.  For the remainder of this posting, I'd like to concentrate on the European situation as seen through the eyes of an American central banker and how Europe's problems may float across the Atlantic Ocean.  Mr. Bullard notes that "events in Europe pit a slow-moving political process against a fast-moving financial crisis".  He must have forgotten about the Congressional deadlock over proposed cuts to the deficit and debt ceiling just 3 short months earlier; apparently, central bankers have very short and very selective memories.

One of his more interesting slides is this one:

For those of you that are not certain what a CDS is (I was one of those too!), it stands for Credit Default Swaps, another one of those magical products dreamt up by the creative minds on Wall Street.  From Bank of Montreal Capital Markets, here is the definition of a CDS:

"Credit Default Swaps (“CDS”) are the base contract in the credit derivatives market. Very simply, this form of swap enables the credit risk of financial assets to be transferred from one party to another without actually transferring ownership of the assets themselves....CDS are similar in design to credit insurance contracts. In a CDS, the default protection buyer makes fixed periodic premium payments to the protection seller in exchange for being made whole on a set amount of notional principal should the specified reference entity experience a “credit event” (e.g., failure to pay, bankruptcy, restructuring). The typically term of a contract ranges from 2 to 5 years, and the typical reference entity is rated investment grade."

Clear as mud, right?  Big, big yawn!  Let's try to explain this in terms that the 99 percent of us can understand.

Basically, a CDS is a form of insurance on credit.  The buyer makes payments to the individual (broker) that is selling the CDS in exchange for protection of the principal of the investment that they are buying the insurance for.  The odd thing is, the buyer doesn't even have to own the original debt investment.  It's kind of like me buying fire insurance on your house even though I don't own any part of it.  For example, you could purchase a CDS on a given government bond, pay the amount set by the market (pennies on the dollar) and then, if the government defaults, you get repaid the full value of the bond.  Banks can use CDS strategies to reduce the risk in their loan portfolios and bond traders can use CDS strategies to reduce their risk to credit that may underperform.  The use of CDS was a strategy that made investors who bet against the American mortgage debt bonds and collateralized debt obligations very rich when the real estate market imploded.

By its very nature as a form of financial insurance, a CDS will rise in value when the market perceives that a bond issuer is likely to default.  Think of it this way; if you repeatedly make claims against your auto insurance, your rate will rise because you are seen as a higher risk customer.  The same applies to the CDS market; when the market feels that a given country is likely to default on its loans, market forces will push the CDS up.  

CDS products are quoted in basis points (one one-hundredth of a percent); for example, a CDS trading at 350 points equals 3.5 percent.  This is how much a buyer will pay as "insurance".  One basis point on a CDS that is protecting $10 million of debt from default (for a given length of time usually five or ten years) will cost the buyer $1,000 per year. As I noted above, the upside for the buyer is that they don't actually have to own the debt (bond), they just own the right to collect the entire $10 million should the issuer of the debt default.  Cool, huh!  The downside is that the seller of the insurance, generally banks, may be "stressed" should they have to pay out all holders of CDS if there is a massive default as I will discuss later.  

Now, back to Mr. Bullard's speech.  Here is a graph from his presentation showing the rather rapid rise in CDS over the past 20 months for six European nations as I showed you previously:

Notice that the CDS for those debt-defying nations of Portugal and Ireland are very high; to insure 10 million euros of Portugal's debt would cost you over 1,000,000 euros per year and Ireland would cost you about 700,000 euros.  In contrast, the CDS for Germany, that European pillar of fiscal prudence, cost under 100,000 euros annually because they are less likely to default than either Ireland or Portugal (or just about any other European nation for that matter) making the insurance on their debt "cheaper".  That said, notice that over the past 10 months, the CDS for the six nations have risen right across the board.  Back in February 2010, all six of these countries had CDS that were trading below 200 basis points, despite the fact that Italy, Spain, Portugal and Ireland were already in some fiscal difficulty.  

Here is a screen capture from CNBC's Sovereign Credit Default Swap quote page (it automatically updates) that will give you some idea of which nations are in trouble (at least, in the eyes of the market):

If we use Germany as the setting the mark as a pillar of fiscal responsibility, their CDS of 98 (less than one percent) shows the level where the market anticipates that there is basically no chance of sovereign debt default.  With that as a baseline, we can see that Belgium, Dubai, Egypt, Hungary, Ireland, Italy, Slovakia and Spain are seen to be problematic and Austria, France and Indonesia are sitting on the fence just waiting for their chance to have debt problems.

CDS aren't necessarily the panacea that they were once thought to be.  With the bailout of Greece, private investors in Greek bonds were asked to take a 50 percent haircut, a plan that has not yet been finalized.  This would through the proverbial monkey wrench into the whole idea of a debt insurance scheme because the payout simply would not be there in the case of a default.  As well, since CDS appear to be a licence to print money, American banks have gone whole hog on the concept.  According to the Bank for International Settlements, guarantees provided by United States' banks rose by $80.7 billion in the first half of 2011 to $518 billion, most of which are CDS on Greek, Portuguese, Irish, Spanish and Italian government debt.  At the end of June 2011, United States's banks had a total exposure of $767 billion in the form of loans to the five aforementioned European countries and the accompanying exposure to CDS.  Banks buy CDS from each other creating yet another house of cards which begs the question "Who is going to cover these losses when there is a large sovereign debt default?".  This nearly happened in 2008 when AIG was nearly unable to cover the principal of the creative mortgage products that it had insured through the use of CDS that they sold to investors.  Could the "too big to fail" mantra of 2008 have created yet another case of moral hazard?   

As an investor, I regularly watch the trends of CDS since they often anticipate what may happen in the world's bond markets.  Right now, the trend is looking very ugly as Mr. Bullard was so kind as to point out.  That said, should Italy be the next default victim, the whole house of cards could implode and Europe's problems may hit American shores harder than we think.  America's banks and their wonderful portfolios of European loans and CDS may come begging, hat in hand, yet again for another bailout when they cannot service the debt backed by their interlocking CDS.  Apparently, the lessons of 2008 were not well learned.


  1. Well done. The bizarre world of CDS is starting to come into focus. Thanks for that.

  2. APJ:
    Thanks so much for this explanation.
    If the bonds do not default, what does the buyer get - nothing?
    If that is the case, he is betting that the bonds WILL default!
    Don Levit

  3. You use Germany as a pillar for fiscal responsibility, hence their CDS is at 98, but the US CDS is at even lower rate at 50. Shouldn't that mean that the US should be used as a mark for fiscal responsibility despite their $15.1 trillion debt, because they're even less likely to default than Germany if we are to take the CDS list at face value?
    I totally agree that the lesson of 2008 has not been learnt at all, and I read Michael Lewis's ''The big Short'' which explains in ordinary language how it all happened and goes deeper into the nature of CDS and CDO's.
    The author claims that the whole of WallStreet didn't know what they were doing, and only a handfull individuals seem to have known what was really going on. I wonder how much of WallStreet and politicians know whats going on again, for to me it looks like they don't, cause if they at least had understood what happened in 2008, they'd have done something by now to regulate those toxic and dangerous CDS and CDO's, and since that has not been done, I'm thinking a bigger short is at hand the Michael Lewis' 2008 Big Short...

  4. Hi Don,

    You are exactly right. No default, no payout. Think of it as shorting a stock or buying insurance and never making a claim.


    I have also read "The Big Short" and it made me want to hide my meagre savings in a mattress! As far as the U.S. goes, I think that, right now, they are getting a pass because the USD is the world's reserve currency. As I noted in the posting, if you look back to early 2010, all Eurozone countries had relatively low CDS. Things changed rather dramatically and my philosophy is that, ultimately, the same thing could happen with the US debt.

  5. "With the bailout of Greece, private investors in Greek CDS were asked to take a 50 percent haircut..."

    Should that read "Greek bonds"?

    I thought the Greek bailout plan was to be "voluntary" so there would be no credit event and the CDOs would not get triggered.

    The politicians did not want to see the CDO (shadow banking) market tested in case it failed.

  6. I hope you can excuse me for being such a nerd, but there is either a math error or I'm misunderstanding this:

    "to insure 10 million euros of Portugal's debt would cost you over 10,000 euros per year and Ireland would cost you about 7000 euros."

    My reading of the chart on the original site is that it's thousands of euros to insure 10million euros. That would make over 1 million euros to insure Portuguese debt and 700,000 euros for Irish debt.

    As an American, I certainly hope my government won't be bailing out anyone caught short by backing or receiving CDSs. 2008 was enough.

  7. Great explanation! What are CDS good for anyway?
    Thus far into the Eurozone crisis, there has been no formal default, so the overleveraged borrowers have received not real debt relief such as longer tenors or lower interest rates.
    And overextended creditors have not been able to draw on the CDS coverage they had purchased, so many have been stampeded into selling Eurozone assets at deep discounts.
    This might do away with moral hazard in lending once and for all...
    See the view from Lisbon in PPP Lusofonia blog

  8. Moderate Poli

    You are right and I was having a brain fart. Note the fix.

    Thanks. I guess I got my points and percents confused. Good thing I'm not a CDS trader!

  9. This is nonsense. Most of those CDS positions are hedged.

  10. Hedging a hedge. Now there's a recipe for disaster. Despite what you may think, some experts are already very concerned that the recent chaos in the sovereign debt markets could expose the flaws inherent in the use of CDS as a means to manage the risk of default. If a bond fails, you expect to collect on your CDS. What if the insurance fails? As well, the recent negotiations with Greece may mean that the solution (a haircut) may result in avoiding the CDS trigger mechanism, leaving holders of Greek debt out of luck.

    Read this:

    ...but thanks for your input anyway.

  11. As Moderate Poli points out, your logic is better than your arithmetic (the German CDS cost quoted also seems a bit excessive).
    But I'd like to hear your thinking on the idea of banning "naked" CDSing (like naked shorts).

  12. You still have Germany and Portugal mixed up in the cost of CDSs.

    What gets me is that you have to pay 80% of a Greek bond price to get a CDS even though the ECB has twisted the arm of the CDS governing board so that they say there won't be a "Credit Event". If that's the case, why is the price so high and why would anyone buy one at any price? Which is true of all of them - why would you want something that will only pay off if the ECB says it will pay off and the ECB is determined that they will not?

  13. "According to the Bank for International Settlements, guarantees provided by United States' banks rose by $80.7 billion in the first half of 2011 to $518 billion, most of which are CDS on Greek, Portuguese, Irish, Spanish and Italian government debt."
    are you tring to say, that the new wall street game started just half a year ago? if so, is this the way american banks are trying to refinance themselfs?

  14. After reading all this I still don't understand any of it but then again I'm not an investing person. Bankers are all crooks. The average person can't even understand what they are doing.

    1. Bankers are all crooks.
      A Valid statement- Why have a bank account?
      Why have a checking account? They are all just a place to store your money if you are unable to hide it inside your house.

    2. The average person not understanding is the problem

  15. Crap, I thought I had fixed the problems with my calculations days ago. Apparently, yet another brain fart and I reposted the same posting with the errors intact. My profound apologies. It certainly is a good thing that I don't get paid to do this!

    ...and you're right, bankers make these "investments" pretty opaque to the 99 percent of us that have a basic checking account.

  16. A printable version?

  17. It is best to be prepared financially in case a serious debt crisis comes on our way.

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