- CDS simply reflect confidence (or uncertainty) levels in future outcomes. People don’t believe in Greece’s ability to put through enough budget cuts to balance its budget. Perhaps like “overly-successful” or just lucky American subprime mortgagees, who are having a hard time downgrading from their unaffordable mansions to one or two-bedroom apartments, it’s hard to go back to a more fiscally conservative lifestyle you feel you outgrew.
- In current sovereign debt crises, CDS represent a miniscule amount compared to the actual underlying government debts currently outstanding. In countries like the Hellenic Republic, it’s about 3%.
- Bad management creates the inherent problems at companies or governments that CDS seems to do a better or earlier job at recognizing or quantifying. In Greek’s case George Papandreou probably gets all the blame although the country’s problem has been years in the making and there were previous prime ministers who’s spending habits have at least partially contributed to what is happening now.
- Secrecy or uncertainty in both the CDS markets and in the accounting books of debt-issuers (corporations and governments) are what really drives panic in these crises. In Greek’s case, not only is there a great deal of secrecy regarding who is actually trading or profiting in Greek CDS, but investors also don’t believe in the government reported economic and financial statistics.
- Bond prices can actually fall further than CDS prices. In Greek’s case, there is evidence that at times the CDS price has reacted in a positive direction earlier or to a greater degree than the actual bond prices and yields have. It is the bond yields that matter as far as Greece’s ability to issue new debt goes.
Disclosure: long all stocks