Tuesday, March 9, 2010

‘CDS may be more of an accurate reflection of pure default risk going forward’

Original posted on FT Alphaville

Deutsche Bank has published the 12th edition of its annual ‘Default Study’, and while it’s worth a read in its entirety, we found the following passage most intriguing. Emphasis FT Alphaville’s:

one of the problems in this study is that for the cash credit market we benchmark everything off the risk free rate which has typically been Government Bonds. For us credit started to be a stand-out buy after the Lehman’s default because that event marked the acceleration of the deterioration in Government balance sheets around the world. Most Governments had to stress their own balance sheets to save the global economy and their financial sector from collapse. Given that spread is simply the difference between the supply and demand of one asset against the other, this period marked the period where credit spreads were set to rally hard. However 18 months on and we are increasingly questioning what is the appropriate risk free rate in an era of perilous Government finances, especially in the Developed World. Going forward, the CDS market may provide the purest way of analyzing what default risk is priced into credit. However with future regulation possible in this market we may be debating how to accurately benchmark default risk for years to come.

Those observations, by Jim Reid and his team, took on an added resonance on Tuesday. Consider the following comments from European Commission president Jose Manuel Barroso, reported in the Wall Street Journal:

The European Commission is considering an outright ban on speculative derivative trades that have been blamed for worsening the debt crisis in Greece, commission President Jose Manuel Barroso said Tuesday.

Fundamental reform in the derivatives markets is needed, Mr. Barroso said. Credit default swaps, which insure against default, particularly when those taking out the insurance don’t hold the underlying debt, need particular attention, he added.

“It is not justified to buy an insurance…on a purely speculative basis,” he said. Mr. Barroso said he will push for international cooperation on the matter. “These markets are as mobile as they are opaque. The commission will raise this question with our international partners, notably at the level of the G-20,” he said.

Another day, another political threat to ban a financial instrument blamed — without evidence, we might note — for causing a financial crisis that would more accurately be attributed to a lack of fiscal discipline.

Hence the irony of Reid’s comments above: as fears mount about profligate government spending across the developed world, the markets increasingly turn to credit default swaps, naked or not. Small wonder these instruments have become politicians’ favourite whipping boy.

No comments: