Sovereign CDS? What’s it good for? Not much, apparently.

Witness, for example, the chart below. That’s CDS on the UK, US and Germany, from Bank of America.

You can see they’ve widened a lot lately — especially the US and UK– indicating that protection from default of those countries is becoming more expensive. In other words, investors are pricing in an increased chance of a credit event happening that would trigger CDS payment.

Unlike in corporate CDS, bankruptcy isn’t a credit event for sovereigns, according to BoA.  Credit events in the case of sovereign CDS include failure to pay on the coupons or principals of their bonds, or restructuring those agreements

What to make of sovereign CDS then? In BoA’s opinion:
… the relevant question is whether a nation such as the U.S. or UK is likely to ever suffer a Credit Event, or if instead it would inflate its way out of a problem. If one believes that a default is unlikely, then such CDS protection is of little, if any, value to hedge against that Credit Event. However, to the extent there is a mark-to-market response, the CDS may provide benefit. This however creates a bit of a conundrum: if there is no ultimate Credit Event, why should there be any mark-to-market benefit?

Moreover, suppose that sovereign CDS referencing the U.S. or the UK were to suffer a Credit Event. Under the financial calamity that likely would follow, it seems doubtful that the protection seller-e.g., a bank or dealer-would remain able or willing to pay principal to the protection buyer. As such, a “hedge” currently recorded is likely of little value, if a protection buyer ultimately needed to exercise. Deep out-of-the-money puts on currency or calls on gold would seem a more effective hedge.

To be clear, if one believes that such a sovereign could default and that the protection seller would be able to pay principal, then sovereign CDS deals with inflation effects by denominating trades in foreign currency. For example, U.S. CDS is denominated in Euros, so that U.S. dollar inflation following a Credit Event should not erode the value of a CDS contract.5

So why the recent widening? Bank of America also has a list of possible explanations:

1. Market participants want a fundamental hedge but do not properly understand sovereign CDS, in the context of U.S. and UK where a Credit Event is less likely than money supply expansion.
2. Attempt to reduce regulatory capital, at a country level, by buying protection against underlying bond risk. But under Basel II (which applies to European banks), there is a zero risk weight for sovereigns with a triple-A to double-A-minus credit rating.7 So this potential explanation is unsatisfactory.
3. Internal regulations that aggregate risk to a country level, and allow a reduction in reserves for country risks that appear to be hedged. For example, a European institution may have purchased U.S. corporate bonds, and hedged those issuers using corporate CDS, but still be concerned (to a degree) about associated country risk. As such, the institution may buy U.S. CDS protection to reduce internal reserves. This explanation would concern us because, as discussed above, the likelihood of exercising that hedge seems low. (One potential exception may be if a foreign bank buys protection from another foreign bank.)
4. Consequence of recent government intervention: Suppose that a European bank wants to hedge risk on a U.S.-based issuer that appears “too big to fail.” If the institution buys protection on that entity, it would be expensive. To save premium, the institution instead buys protection on the United States, assuming that the only way the issuer defaults is if the United States defaults. On the surface, that may seem a way to save premium, but again as discussed above, the ability to exercise the sovereign CDS hedge seems low.
5. Investors who have no interest in exercising a hedge from a fundamental perspective, but look for a short- to medium-term trading opportunity before investors realize the problems with such sovereign CDS: For example, an investor may sell protection on recipients of TARP money and buy protection on the United States (as a provider of rescue funds). At least in the banking sector, these trades would have performed poorly of late, because bank CDS has underperformed U.S. CDS.

Too right. In particular, the chart at left, from Think Big Bespoke Investment Group, shows the one month percentage change in default risk. The US isn’t the biggest increase in the past month — but a 68 per cent jump is nothing to be sniffed at, either.The amazing thing here is that CDS for countries, with the exception of Lebanon and Argentina, is rising across the board.

This makes sense intuitively — there’s a financial crisis, governments are pouring money into their respective economies, etc., so the theoretical risk of default would be rising.

However, as BoA notes, there’s an important distinction between the developed countries, where debt is almost all denominated in local currency, and emerging markets, which have most of their debt in foreign currency. In other words, just because Argentina CDS dropped 10 percent last month, doesn’t mean you should pile in. Argentina, unlike the US, can’t print dollars to meet its debt obligations (at least legally).

Anyway, this all leaves BoA with a most unsatisfactory conclusion:

…we find no satisfactory fundamental explanation for U.S. and UK sovereign CDS widening. Clearly, sentiment against the potential cost of sovereign intervention appears clear from wider CDS spreads. However, given the currency implications, the CDS strategy appears built on a weak fundamental base.

A rather blunt translation: Stop preparing for Armageddon, you’ll all be dead anyway.

Related link:
Country default risk rises across the board – Think Big

This entry was posted by Tracy Alloway on Tuesday, December 16th, 2008 at 9:01 and is filed under Capital markets. Tagged with CDS, UK, us. Edit this entry.