IP DM Sovereign CDS (2006-2011)
Like many derivatives products dreamed up by Wall Street’s financial innovators, the Developed Market (DM) Sovereign Credit Default Swap (CDS) market was borne out of the desire to transfer risk off the books of banks to investors suited to managing those risks. Following the successful establishment and effectiveness of risk transfer in the corporate CDS market, the onset of the Asian Financial Crisis spurred growth in trading in Credit Default Swaps on Emerging Market countries’ debt. However, legal documentation issues relating to the 1998 Russian bond default hinted at the structural problems embedded in the contracts, subsequently confirmed when the economically coercive 2001 Argentinean so-called “Mega-Swap” did not trigger CDS. Indeed, even though Argentina eventually repudiated its debt unilaterally, many protection buyers’ swaps had already expired by then, and trading volumes in EM CDS fell substantially, only really recovering post the 2003 overhaul of ISDA’s rulebook.
It is then, perhaps, surprising that despite proven complications related to the terms under which EM Sovereign CDS would pay out that market participants extended the concept to cover Developed Market Sovereigns in 2006. Arguably, along with its siblings ABS CDS, made famous by Hedge Fund manager John Paulson’s multi-billion dollar bet against the US Subprime market, trading in DM CDS took off as a way to hedge the risk of countries who had been forced to assume the liabilities of their banking systems coming under pressure themselves. But as with earlier EM-specific non-triggers, the Icelandic government’s decision to put its banks into administration in November 2008 rather than default on its own debt, resulted in its CDS falling from as wide as 1400bps to current levels closer to 320bps. The LSE’s Professor Willem Buiter, a former Bank of England MPC member, in early-2009 asked the question “Is the London Reykjavik on Thames?”, leading to CDS on the UK to spike to as high as 166bps, but this sparked many to point out that the UK’s debt was denominated in Sterling, which the Bank of England could print an unlimited amount of. A month later, in March 2009 the Bank of England’s decision to purchase £75bn in its Asset Purchase Programme seemed to support this view, despite a second widening of UK CDS in the run up to the 2010 General Election as investors worried about the UK government’s commitment to its medium term solvency.
Nevertheless, the incoming PASOK-led Greek government revealed in November 2009 that the country had under-reported its deficits, triggering the onset of the Eurozone crisis, and Greek CDS began to widen, culminating in the April 2010 EU/IMF bailout of Greece, and a month later, in the face of contagion to other European government bond markets, the establishment of the European Financial Stability Facility (EFSF). An explosion in trading of DM CDS on Eurozone peripheral countries’ debt ensued as hedge funds sought to speculate upon the likelihood of an eventual Greek default and banks sought to hedge their exposures to those countries built up over the preceding decade.
Inevitably, faced with the political cost of bailing out foreign countries, European politicians lashed out at the CDS market, blaming it for breeding panic and allowing speculators to “bet” against bond markets and the Euro. As seen in the 2008 Global Financial Crisis, banks under pressure, along with politicians, blamed short sellers and speculators for spreading rumours and exacerbating the situation, while speculators argued that the market was merely “the messenger”, pointing to fundamental problems with balance sheets. As financial market pressures became ever more severe, European policymakers resorted to short selling bans and attempted to implement a ban on CDS trading. The debate continues to rage over whether the CDS market caused or exacerbated the Eurozone crisis, or whether the crisis was inevitable.
But what eventually killed the Developed Market Credit Default Swap market in the end, was the agreement with the Institute of International Finance (IIF), representing banks owning Greek bonds, to accept a 50% haircut on their holdings. The possibility that despite such a large haircut on Greece’s debt, that CDS contracts would not trigger, led many investors and bank hedging desks to question the value of their CDS contracts. The repercussions soon spread, as those institutions that believed they had hedged their bond holdings, or bet upon a Greek default, rushed to sell their contracts before the price collapsed. Volumes soon collapsed as it became evident that developed market governments had the ability to force their banks into taking haircuts without rewarding what they view as speculators.
Developed Market CDS soon faded into history alongside Perpetual Floating Rate Notes, Libor-cubed Notes, Asset Backed Collateralised Debt Obligations, War Loans, Endowment Mortgages and other financial products that were found wanting.