As credit default swap spreads for 5-year British government debt rose to 150 basis points last week, one European regulator raised a significant concern regarding the balance sheets of banks on both sides of the Atlantic. "If you follow the rating agencies, well and good, but if you apply default risk prices to banking assets, capital adequacy ratios of nearly all western banks are open to question," she warned, after watching Euro-based spreads on U.S. government debt rising to 75 bps, and after noting that few CDS price-makers were willing to provide firm quotes for longer-dated sovereign reference instruments.
The issue is not as technical as it appears in the first instance, given that professional debt traders are no longer predicating their strategies on the credit ratings generated by the mainstream rating agencies.
Also, with the unprecedented amount of sovereign debt (and sovereign guarantees) required for all the bailouts and rescues, the old "countries-don't-default" maxim has become an acceptable subject for debate. As one badly-burnt investor in Argentina bonds said last week, "each time they (the governments) restructure their debt, you are forced to take a haircut, so I'm not really sure what a sovereign default means any longer."
Needless to emphasize, as the relatively liberal interpretation of the definition of sovereign default gathers momentum, those pricing credit default swaps will be encouraged to take spreads on U.S. government risk well into the 150-200 bps range over the next few months, for three reasons. Firstly, there is not enough evidence yet to show that the latest round of stimulus packages will achieve, in part or whole, their lofty objectives.
Secondly, CDS dealers are slowly warming up to the possibility that the Obama administration will simply introduce another bailout package, for another hundreds of billions of dollars, if economic conditions worsen in the second half of 2009. And, thirdly, if CDS spreads (and related default probabilities) on government risk are applied to the valuation of assets within the banking and insurance industry, the "systemic risks" Fed Chairman Ben Bernanke talks about are still very much intact.
When pure technical grounds are applied to the deterioration of U.S. government credit, it is apparent that the structural core of the credit markets is being destroyed. For instance, viewed from the prism of default risk coverage, the risk-neutral yield on 5-year treasuries should be closer to 2.40% (instead of 1.63%). Or, to take another example, interest rates on government-backed debt issued by banks and other bailout candidates should incorporate CDS spreads pertaining to the government offering such guarantees.
In the broader debt marketplace, investment-grade securities need to be thoroughly re-priced unless, of course, one is prepared to acknowledge that certain American corporations must be rated higher than the U.S. government, a position which more than a few hedge funds are adopting of late. And if default risk on the U.S. government continues to rise, what are the pricing consequences for mortgage rates?
Numerous portfolio managers appearing on CNBC and Bloomberg have been stressing that the fate of the treasury yield curve is inextricably linked to the fate of the U.S. dollar, and that default perceptions will have only a limited impact on the credit environment. That may be so, in theory. However, since interest rate adjustments, and currency interventions and central-bank swaps, are being engineered globally on a haphazard basis, it is difficult to predict where the dollar will be even three months from now, let alone in three years.
Complicating the domestic bond scenario is the proliferation of multi-tiered government-guaranteed debt issues in the U.K. and Europe, which are now providing banks, insurance companies and asset managers with a unique ability to arbitrage between credit ratings, CDS spreads and effective yields. The availability of such arbitrage, which does not require any high degree of sophistication, signifies serious structural flaws which, in turn, are an essential ingredient of the overall systemic risk matrix.
Finally, the inability of the rating agencies to keep pace with the fundamental and far-reaching changes in the underlying economic climate is by itself a sign of the times. Which brings us to two final, all-important concerns with respect to systemic risk within the credit markets.  What percentage of assets listed in banking and insurance balance sheets are over-valued today, with the benefit of investment-grade ratings?  And how many collateral debt obligations [CDOs], CDS and index put insurance contracts are retaining good-standing status today due to the inability of the ratings agencies to properly quantify counterparty risks?
In the absence of specific descriptions of assets (Levels 1, 2 & 3, per FSAS 157) in the balance sheets of Citigroup (C), Bank of America (BAC), Goldman Sachs (GS), Morgan Stanley (MS), JPMorgan Chase (JPM), American International Group (AIG), Wells Fargo (WFC) and General Electric (GE), it is impossible for even institutional investors, let alone individuals, to ascertain the true extent and nature of systemic risks which continue to threaten the financial system. Perhaps the SEC can help and make such disclosure mandatory with immediate effect. Perhaps.
Disclosure: Short GE, GS