Sovereign Default Outlook Causes Panic in CDS Market

Pakistan needs $15 billion within days to avoid defaulting on its foreign loans. Yields on Argentina long term bonds soared above 30% yesterday, from a mere 12.15% just a month ago. Hungary, which has already received an emergency loan of 5 billion Euros from the European Central Bank, is now tapping the IMF for more money. Most disturbing of all, perhaps, is the fact that credit default swap prices for Russia have breached 800 basis points in limited trades in the Asian time zone Thursday.

Naturally, the International Swaps & Derivatives Association (ISDA) and The Depository Trust & Clearing Corporation (DTCC), both of whom created confusion pertaining to the Lehman CDS settlement on Tuesday, are thus far maintaining a stoic silence with respect to the emerging market bond complex. Neither organization is prepared for the chaos and panic which is destined to continue well into 2009.

CDS pricing specialists had assumed that the development (and supposed upgrading) of credit risk assessment methodologies in recent years had generated error-free arbitrage windows, essentially characterized by the risk neutral gap between emerging market yields, credit default insurance and US treasuries (or Libor). The shift from probability-based pricing models derived from the works of Black, Scholes and Merton (1974) to arbitrage-driven risk premium calculations created the generally accepted notion that sophistication had, at last, succeeded in capturing the consequences of credit and rating events within credit default swap contracts.

In reality, hard facts from the global economy prove that neither probability nor arbitrage is a valid methodological premise, at the very outset. On the one hand, the two-dozen-plus sovereign issuers (potential defaulters) are unable to state when and if they can comply with their debt service obligations. On the other hand, there is no credible analysis surrounding the root causes of the crisis in domestic economies.

Pakistan, for example, blames its crisis on higher food prices; but reliable information from Pakistan’s market towns confirms that the problem is more due to hoarding and smuggling rather than any genuine shortage of grains and lentils (and onions, of all items). The East European financial systems are merely paying, somewhat belatedly, for the failed communism-to-democracy transition which, for all practical purposes, began in 1991, and which was never secured in economic terms: industrial development, agricultural productivity, job creation and welfare benefits.

If any further evidence of the serious flaws in pricing credit insurance for sovereign debt is required, then Latin America has that in abundance. Rating events are due to pick up momentum shortly. And to compound rating downgrades will be the steady stream of credit events, leading to inevitable debt restructurings. In other words, two years from today, the underlying reference instruments (sovereign bonds) in a significant proportion of credit default swaps might well be replaced altogether!

While the total outstanding emerging market sovereign debt is a matter of public record, estimates of the size of the related credit default swap market range from a low of $4 trillion to a high of $12 trillion. But, size apart, it is important to recognize that low liquidity levels in the emerging market debt matrix must have severely constrained counterparty risk integrity in credit default swaps: i.e. the applicability (or, rather, the inapplicability) of the much-touted (by the ISDA and DTCC) mark-to-market rule on an ongoing basis.

Where will credit default swaps be priced in an environment where emerging market bonds offer yields of 25 and 30 percent, and beyond?

Short Russia risk at 800 basis points appears a highly attractive proposition. Other recommended bets: short Nicaragua and short Venezuela, depending upon the availability of a quote. The biggest gains, however, will be made in short positions on sovereigns which, as of today, are on the fringes of the investment grade category---check the S&P and Moody’s websites for specifics.

Disclosure: none

Comments

[Philly Jim:]

Short the entire emerging economy - it's going black, forget about red. Take a look at the lifeblood of these economies, the indexes like Baltic Dry, etc.. The middle eastern economies are not going to be immune, they are betting on a strong consumer in the emerging markets but they have totally destroyed the demand for their oil in these emerging markets - the Western economies are just about the only ones who are not off oil burning cars yet and will be before 2020 which means disaster for those dependent on an oil economy.

2008 Oct 23 05:27 AM

[BenBullBear:]

I'm curious. Where do you get your estimate of $4 to $12 trillion of notional amounts for sovereign debt of emerging markets? The figures that I saw point to $1.4 trillion of CDS sold (notional amount) and this includes both emerging and mature economies (sovereigns).

You can find the data in the BIS tables for Dec 2007.
www.bis.org/statistics...

If you have evidence that this amount is a fraction of reality then we have a serious problem on our hands cause this would be 10-30 times the presumed $400 billion of notional insured on Lehman's debt!

Still, $1.4 trillion is no small amount considering that Lehman's debt gone belly up was enough to kill AIG and cause many others to scramble for some bailout money!

Anyone else can corroborate the $4-12 trillion of CDS written on emerging nation debt? Thx! Ben

2008 Oct 24 02:59 PM

[Rakesh Saxena:]

Thanks Ben. I will check these BIS numbers for you when I can call them this coming week, but the US$1.4 trillion figure is wrong, perhaps dated. The International Swap and Derivatives Association estimate is US$60 trillion notional, and this figure does not account for the huge additional non-CDS default risk insurance contracts currently outstanding. That said, my estimate is based on the proportion of sovereign insurance trades indicated by market makers over the previous year or so, and that estimate stands to be corrected if other facts come to light. - Rakesh

2008 Oct 25 01:12 PM