New Derivative Instrument: Sovereign Credit-Default Swaps (CDSs)
For those investors who are betting on the total collapse of the government debt market, there is now an investment vehicle that is made just for you! by Bill Gee
(centrist)
Tuesday, March 1, 2011
Okay, it's not exactly "new", but it is gaining popularity as governments, especially those who are tied to the Euro, get closer and closer to the edge of defaulting on their government debt.
The ability to "bet against" any debt instrument, which is commonly referred to as a "swap", has been around since the late 1990's and only really gained notoriety when a small group of investors made Billions of dollars in 2008 by betting against the Sub Prime housing market and nearly drove insurance giant, AIG out of business.
For those of you who have not read Michael Lewis' book "The Big Short", or if you were living under a rock during the worst of the financial crisis, here is basically how a Credit-Default Swap (CDS) works. (If you have not read the book, I highly recommend it!)
Let's say that you own a Bond and you are a little unsure whether or not it's going to pay what it's supposed to pay. You have two options. If you sell the bond, you might be able to recover what you paid for it and then buy another bond that you feel a little more confident about. If selling the bond will generate too much of a loss, you may just want to take out an insurance policy on it. The policy simply says that should the bond lose more than 20% of its original value, the insurance policy (a CDS) will pay you the difference. That way, if the bond tanks, you have protected your investment. The level of premium you pay on the policy is based on the insurer's assessment as to the level of risk that the bond will actually default.
Now let's say that you have very little confidence in a particular bond market. In other words, you think the whole thing is about to implode so there is really no point in investing in any of these bonds. What you can do now is take out multiple Swaps on a single bond that you own from different sources. Since a Swap is not like a traditional insurance policy, these things can be bought and sold on the open market. In fact, you don't even need to own the bond you're purchasing the Swap on. You're just purchasing the "bet" that a particular bond is going to default.
This is how a few very intelligent investors who saw the housing crisis coming were able to make Billions by betting against the entire system of Mortgage-Backed Sub Prime bonds.
During the height of the crisis, many lawmakers and bankers wrongly accused those shrewd investors of "causing" the crisis. That somehow, since they profited off of the stupidity and greed of Wall Street bankers (and ultimately the taxpayer), that they must have somehow engineered the chaos. Not so. In fact, these investors were branded as fools by the bond community up until housing prices started to drop. The rest is history.
So you may be asking yourself, "Hey, what can I "short" so I can make Billions?" The answer may be Sovereign Credit-Default Swaps (CDSs).
A CDSs works in much the same way as any normal CDS, except this time, the bonds that you are betting against are Government Treasury Bonds. Yes, bonds that are pretty much guaranteed to never default because they are backed by the ability of governments to tax their own people in order to pay them. In other words, you are betting on the complete collapse of a sovereign government. If you have the ethical fortitude to do that, you should be aware of certain risks.
For illustrative purposes, let us choose an easy target: Greece. As a member of the European Union, all Greek sovereign debt must be paid in Euros. As a member of the common currency, Greece can only raise the money to pay its debts through taxation and the sale of government assets since only the European Central Bank has the authority to print new currency. Let's say you have taken out a CDSs on Greek debt because you believe that Greece will eventually default, which is entirely possible given what we know.
One day, the Greek government announces that they will have to default on their debt. They have taxed their citizens and cut spending to the point where they cannot cut and tax anymore and they still cannot pay their obligations. Ready to dance to the bank? Not yet. If the EU decides to lend more cash to Greece, then your CDSs will not pay out...yet.
Your CDSs will only pay out if both the Greek government AND the EU decide that they have no choice but to default on the sovereign debt. To do so would likely result in the collapse of the entire Euro zone as all Euro-backed debt would lose confidence in the marketplace. This might result in the nations of Europe to revert to their previous currencies, or it might result in a total economic collapse of the region. If you believe that either scenario is likely, then you should not buy a CDSs on Greek debt.
Let's say that the Euro zone does collapse, Greek bonds have defaulted, and your CDSs is now scheduled to pay you Billions. Before counting your haul, consider this:
During the Financial Crisis, insurance giant AIG held the lion's share of the liability for all of the CDS's out in the market. Without realizing it, they were on the hook for hundreds of Billions of dollars. If they were forced to pay out, this would have bankrupted the company and led to a complete collapse of the insurance industry worldwide. If it was not for the Troubled Asset Relief Program (TARP), the crisis of 2008 would have likely led to a Second Great Depression or worse. Because the Government was able to step in and essentially "rescue" the financial industry, those who purchased CDS's made their Billions, AIG was able to continue to exist and the macro-economy was saved from certain disaster. (At least temporarily!)
Since Greek debt is paid in Euros, your CDSs would be insured in Euros. So if an event were to occur where the CDSs would actually pay out, it is unlikely that anyone would be able to pay you since there wouldn't be a central bank any more. In other words, nobody would be left to bail out anyone, and you won't see one penny in payout. In the unlikely event that someone were to give you your money, it would be in Euros, which would be worthless.
Some companies have gone so far as to start marketing CDSs securities on US Treasury debt in an attempt to cash in on the uncertainty of the US Government's ability to pay down the National Debt. To purchase one of these derivatives would be an exercise in futility for the same reasons why purchasing a CDSs on Greek debt makes little sense. The only scenario where you would actually see a payout on such an investment is if some larger economy than the US decided to bail us out. (This is not likely because at last count, the US was still the world's largest economy.) The US also has the ability to simply print new currency to pay off its debts. While this would reap havoc for inflation, you still would not see a penny of payout. Finally, if the US economy were to completely collapse, there wouldn't be anyone around to pay you, and there would be no means in which to get anyone to pay you even if they could.
Alas, it appears that the "winners" in the "Big Short" will only be a one-time deal. If the worst actually happens and the world economy actually does collapse, it's unlikely there will be any "winners".
3/15/2011 Update: In the wake of the Japanese earthquake and tsunami, the market for CDSs on Japanese sovereign debt has jumped to an all-time high. It appears that some investors are betting that this disaster will be the final nail in the coffin for the Japanese economy.
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Posted By: Bill Gee
Date: July 6, 2011 12:47:01 PM
Update: Portugal's sovereign debt was downgraded by Moody's to Baa1 (junk status) on July 6, 2011. Ireland's debt is close behind. If the US doesn't get their act together on the debt ceiling by the end of July, they will also see their debt rating slashed. In the event of a default, even a temporary one, the CDSs will make a payment to investors. Is there enough insurance in the world to prevent a total economic collapse? Doubtful.
