How Will Hungary Shape Eastern European CDS Prices this Week?

Hungary is in crisis mode today. While an IMF lifeline is negotiated, credit default swap prices for Hungary sovereign debt are set to fluctuate wildly, from a low of 420 basis points to a high of 600, and beyond. The rest of Eastern Europe waits with bated breath, hoping that Hungary default insurance costs will not follow the path shown by Ukraine (1,900 basis points, 3 years).

The Forint has dropped a whopping 30%-plus against the dollar since June. Hungary's benchmark interest rate has risen by 3% last week. The domestic bond market is virtually frozen. And, as official statistics tell the sorry tale, foreign currency loans make up almost 62% of all Hungarian household debt!

The CDX emerging market credit default swap index rose to 1,100 basis points this week and levels of 1,300 basis points are well within the realm of reality in forthcoming days. If index spreads do widen as anticipated, the impact on East European prices will be devastating.

Bond yields for all former Soviet states are rising, and market-makers are, in any event, currently revising their assessments of the relationship between yields on bonds and default probabilities implied by those yields. By all accounts, a serious collapse in the emerging market default insurance market, following the Argentine debacle, has been prevented (for now) by announcements that Iceland, Belarus, Pakistan, Ukraine and Hungary were lining up for IMF subsidies for "initial" requests totalling $20 billion.

The common, and perhaps dangerous, perception today is that IMF bailouts will serve to create a cap on default risk for Hungary (rated BBB+ S&P, negative watch), Romania (BBB-), Bulgaria (BBB+), Ukraine (B) and Serbia (BB-). That perception might well turn out to be an illusion, depending on what conditions the IMF imposes. The restructuring terms themselves could create credit events, rating events or even a fundamental revision in the underlying reference instruments for outstanding credit default swap contracts.

Most worrying of all is the willingness of traders to allow swap prices for a resource-rich country like Russia to approach 900 basis points. Last quotes for Bulgaria (430 basis points, mid-rate, 3 years), Romania (485 basis points), Estonia (460 basis points), Latvia (725 basis points) and Lithuania (450 basis points) revealed an acute shortage of genuine bids.

Pakistan, for information purposes, is now quoted at 1,050 basis points, from a low of 150 in February! Pakistan is, in turn, impacting upon India, where buyers around 425 basis points have disappeared altogether.

Stock position: None.