Tuesday, December 16, 2008

'Wider' fools

(Bank of America opines as to why U.S. and UK CDS are widening and concludes that folks are stupid. They fail to consider that there is a constraint on the printing press for bubble derivative scrip i.e., what folks are willing to pay for it, thus leading to selective defaults, and that in the face of the current monetization strategy this might be a proxy for shorting long bonds. - AM )

FT Alphaville
Posted by Tracy Alloway on Dec 16 09:01

Bank of America 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. (However they also state that Credit Events in the case of sovereign CDS include failure to pay on the coupons or principals of their bonds, or restructuring those agreements ... which is a very credible explanation. - AM)

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.

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.

No comments: