Streetwise Professor

November 21, 2011

SWP Early Edition: Sovereign CDS

Back in the summer I argued that sovereign CDS are acutely vulnerable to wrong way risk.  Indeed, the problem is so severe as to call into doubt the viability of these instruments.  From today’s Dow Jones News Wires:

But some market participants said that, if risk aversion from Europe spirals out of control and credit markets freeze, a large firm could fail to meet its obligations in a credit-default swap, setting off a chain reaction that threatens to destabilize the global banking system.

They are urging closer scrutiny of banks’ gross sovereign CDS positions and of the interconnectedness of the banking system.

“When there is a high degree of correlation between the underlying risk and that of the hedge counterparty [in this case, the sovereign and a bank selling CDS], can you rely on a payment from your protection seller?” asked Joyce Frost, partner at Riverside Risk Advisors LLC, a derivatives consultancy.

The correlation may be so strong, she said, that if Italy, for example, continues to deteriorate, the protection purchased from a highly correlated European bank may not be worth as much as originally thought. The value of that hedged position would be worth less than if the CDS were written by an uncorrelated counterparty–a U.S. or Canadian dealer, for example.

This is a phenomenon market experts call “wrong-way risk.”

Katy Burne goes on to argue that “[t]he lack of sovereign CDS clearing makes individual institutions more vulnerable to a messy default.”  This is fundamentally incorrect.  Clearing does not make wrong way risk go away because banks are CCP members, and would be on the hook in the event that a big loss on sovereign CDS caused a bank/clearing member to default.  In particular, the senior tranche of a CDO-like nature of CCP default funds makes them acutely vulnerable to wrong way risk.

Wrong way risk is intrinsic to sovereign CDS.  If big sovereigns are at risk of defaults that would cause payouts on CDS–heck, if even sovereigns that seem small in the scheme of things, like Greece, are in trouble–banks are likely to be in trouble.  The correlation is a fundamental feature of the instrument.  Whether banks are the ultimate counterparties in bilateral trades or via CCPs is immaterial: the problem is there.

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  1. […] – Sovereign CDS, still going the wrong way. […]

    Pingback by FT Alphaville » Further reading — November 22, 2011 @ 2:26 am

  2. As someone who works in one of those banks, I can say that banks have been scaling bank their credit trading business quite a bit this quarter. Especially hit were the Sov CDS in emerging markets.

    Comment by Surya — November 22, 2011 @ 7:18 am

  3. The sov debt CDS market was rendered null and void by the recent sub rosa machinations of the euro banks to get everyone to agree to a “voluntary” haircut of 50% on Greek debt to avoid a credit event that would trigger a CDS payout. This amounted to a regulatory taking by a pseudo-regulator (ISDA). What makes matters particularly vexing is the banks holding the sov CDS protection continue to treat these contracts as if they were bona fide hedges. So when they report v@r exposures they pretend they’re hedged. The entire market knows the banks are not hedged. But the lack of transparency in the banks’ balance sheets forces the market to guess at how bad the problem really is (vs what the banks aver). The next set of negotiations to ensure a credit non-event in sov debt land (likely Italy or Spain) likely will require even deeper haircuts to avoid bankrupting sov-debt CDS writers with the declaration of a credit event requiring a payout on sov debt CDS.

    Talk about the rock and the hard place: Holders of CDS “hedges” have to rig the market (ad hoc) so their hedges never payout. They can’t risk allowing a credit event that triggers CDS payouts. Good for them that they control the pseudo-regulator (ISDA).

    Here’s another vexing matter: If I’m not mistaken, sov debt is carried at par per Basel II and III. So, the underpinnings of the banks’ capital structure, their assets + hedges are complete illusions. The governments that issued the sov debt are insolvent. The banks that wrote the CDS contracts also will be insolvent if they cannot keep a credit event from being declared. I’m not aware of any situation in which the collapse of the underlying market (sov debt in this instance) is accompanied by the collapse of the hedge market for that underlying. This truly is an instance of epic poor design. The banks quite literally have infected themselves with a financial virus of their own design for which there is no cure.

    Comment by markets.aurelius — November 22, 2011 @ 9:53 pm

  4. @markets.aurelius. Dead men walking. But don’t forget that the sov debt treatment in Basel was pushed by gov’ts that wanted to sell debt at preferential rates. They’ve created a huge steaming pile of wrong way risk. It will not end well, but it will end soon.

    The ProfessorComment by The Professor — November 22, 2011 @ 10:46 pm

  5. […] links: SWP Early Edition: Sovereign CDS – Streetwise Professor Trade Information Warehouse – DTCC 99 per cent of credit […]

    Pingback by FT Alphaville » CDS indices hit records while uncleared sovs spike — November 23, 2011 @ 7:27 am

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