Pricing CDS on the EFSF | FT Alphaville

Pricing CDS on the EFSF

Euro basket-case trade for sale! Contains more correlation and wrong-way risk than you can shake a stick at.

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It’s CDS referencing the EFSF itself, and it’s… already dead on arrival, according to IFR’s Christopher Whittall:

Dealers are shying away from offering quotes on credit default swaps referencing the European Financial Stability Fund, despite customer demand for the instruments.

Five major dealers contacted by IFR all denied quoting CDS on Europe’s sovereign bailout fund, citing the potential political fallout of doing so.

“Political fallout”, you say? That’s code for “reputational risk”. Some banks have committees for just that thing. Call it the “Committee for the Prevention of Politicians using us for Target Practice”.

Don’t leave yet though, as this is positively heart-warming (emphasis ours):

“We had some requests, but we turned it down,” he said. “I don’t think it’s the right tool. In my own personal view it’s wrong to do that – I don’t think banking will be better if we start doing EFSF CDS.”

Please put this guy in charge of all new product development. Immediately.

In the meantime, FT Alphaville has made an attempt at putting together a fantasy price for EFSF CDS. A fantasy EFSF (fEFSF, pronounced “fef-sef”) if you will. Here’s the result:

And here’s how we tried working out the price.

To construct this, we started with the EFSF’s “amended contribution key” setting out the varying sizes of the sovereign guarantees that provide its backing. (“Amended” — that’s minus Greece, Ireland, and Portugal).

Then we took out the really small contributors (apologies to Cyprus, Estonia, Luxembourg, Malta, Slovakia, Slovenia) because the CDS outstanding are small, as are their weightings, hence unlikely to affect the calculation anyway. Special mention though for Slovakia, given the song and dance of their EFSF guarantee. This still left us with these guys, covering 98 per cent of the contributions:

Austria 2.99
Belgium 3.72
Finland 1.92
France 21.83
Germany 29.07
Italy 19.18
Netherlands 6.12
Spain 12.75

Then we did a weighted average of the 5-year CDS spreads of the above sovereigns. The weights used were those of their percentage contributions.

By construction, all of the individual sovereign CDS are going to be very highly correlated with the EFSF, but we raised an eyebrow when we saw that the two most correlated for the time series starting on June 1st were Italy and France. The high weight on Germany surely guaranteed (haha) it a spot?

FT Alphaville GeekStats Box
Before any stats people start to turn green – our dodgy, circular construction aside, we nod to acknowledge that the very definition of correlation means that more volatile series are going to seem more correlated, i.e. these estimates are likely to be biased. So while Germany may move more than Italy with the fEFSF, we wouldn’t know for reals unless we started testing for heteroscedasticity and if found, started adjusting the correlation measure accordingly.

In any case, we are a bit torn over the whole CDS referencing the EFSF thing. On one level, this is a heartening story about how at least some banks thought about writing protection on it, given that there has been at least some client demand (as the IFR article states – go read the whole thing), but backed away cause it was just wrong.

Admittedly, FT Alphaville’s stomach also did some minor acrobatics at the thought of even making the above chart, even in jest.

On another level though, since when did credit derivative markets start caring about what does or doesn’t make sense for banking as a whole? There is a track record of writing contracts that are nuts and if anyone disagrees, we’ll happily hit them over the head with the ABX.HE.BBB index that references subprime mortgages (07-01 series now trading at a price of 1.44 pts) or CDS on Saudi Arabia (for the Kingdom of No Debt, there is a net notional outstanding of $397m spread over 305 contracts as of last week).

Unencumbered by considerations of the benefits to banking on a more holistic basis, does the EFSF look like it’d be something that would have CDS written on it? Let’s do this in questionaire format:

Dear Potential CDS Entity,

Figure out if you should have CDS written on you in under three minutes!! Just answer these four easy questions:

1. Do you issue your own debt?

2. Are you a counterparty to financial contracts?
No comment

3. Are you a proxy for anything? If so, what?
Impending doom The health of the eurozone, Europe more broadly, and the world economy

4. Would evil speculators and/or pension funds want to take a view on your creditworthiness using more leverage than bonds allow?
You’d have to ask them. But let me know what they say, will you?

Thanks for filling out this form.
No biggie. After struggling to issue bonds, we’re having a bit of a breather anyways.


Disclaimer: Having CDS written on you has a 1 in 2 chance of negatively affecting the prices of your bonds, a 1 out of 3 chance of making it cheaper to fund yourself since investors can hedge their exposure, and a 1 out of 6 chance of prompting confusing headlines about you. Half of all statistics are made up and the ones in this box are no exception. If you are a supranational backed by sovereigns, the ban on naked sovereign CDS may, or may not apply to you – consult your MEP.

So that’s a yes then. The proxy value alone would seemingly prompt trading of CDS on the EFSF, were it not for the need to keep up appearances.

After all, CDS are written on supranationals. The European Investment Bank and European Bank for Reconstruction and Development are two examples of that. Volumes on those two are very, very low though, and they are very different entities to the EFSF. For a start, the EIB is a bank, with access to central bank liquidity, and its shareholders look like this (click to enlarge):

With the EFSF though, it’s all about self-referencing, which is another way to describe the wrong-way risk involved.

To have a quick and dirty example of that, think about whether you’d buy protection on France from BNP Paribas, or protection on the UK from RBS, or protection on Germany from Deutsche Bank. If the CDS spreads on any of those banks started widening out significantly, it’s safe to bet that their lender-of-last-resort sovereigns will start widening too. This is something we’ve seen happen a lot over the last few years. Similarly, one can see banks widening with their sovereigns, as their backstops look increasingly vulnerable.

If you did any of those trades, you’d be deeper in-the-money, but at the same time, your counterparty is starting to look increasingly fragile (and you’re probably having to hedge against the possibility that they might not be able to pay you too).

The EFSF will be exposed to the creditworthiness of the same countries that fund it. And yet it’s AAA. Didn’t we learn that correlation is bad in these situations? Or that self-referencing is bad? Even hedge funds that eat high correlation for breakfast would baulk at this since the compensation isn’t anywhere near enough.

Anyway, let’s look at how that creditworthiness has been doing as measured by real financial instruments, instead of our made-up ones. Here’s the recent performance of EFSF bonds:

That’s one sobering chart. Looks like the market is losing confidence in something. Have fun hedging. After all there are plenty of other less overtly reputationally damaging ways to do it, after all..

Related links:
Dealers reluctant to quote CDS on EFSF – IFR
EFSF: How not to structure a CDO – Euromoney