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.