Wednesday, March 11, 2009

Pascal's Wager For The Neomarxist Generation (Or The Rampant Confusion Among Risk Traders)

Lately more and more investors have been asking the same question: why are traditional metrics of market stress and credit supply not indicative of what the market is doing? In particular, they look at the VIX index as well as 3 month LIBOR, which, last time around exploded when the market reached its post-Lehman lows in November. Why should it be different now, when the market reached a 12 year low last week and financial company CDS levels hit all time wides, yet both the VIX and LIBOR have barely budged?



It is gradually becoming evident that the primary culprit for this strange behavior is likely the government itself with its recent policy change to guarantee virtually all short-term markets, especially in credit (via its alphabet soup of recently instated programs). And the market has responded appropriately by pushing sovereign risk to record highs, not only in the U.S., but in other systemically critical countries that have also taken on liability guarantee programs such as Germany and the U.K.



The transfer of default risk to the sovereign's balance sheet is a novel phenomenon (at least in capitalist societies) and over the past 3 months traders have been scratching their heads on how to trade this. The only logical trade that has emerged has been purchasing credit protection in sovereigns as spreads have tightened in companies that are either explicitly named as too big to fail or are in industries affiliated with them. At latest count, the largest guarantees were within the financial, insurance and automotive space. As the Moody's thesis plays out and any number of the upcoming companies with near $300 billion in cumulative debt accelerate their bankruptcy filings, it is inevitable that the government will increasingly assume more and more risk to prevent the wholesale closure of the U.S. economy and the loss of additional millions of jobs.

The problem with the sovereign CDS trade, as has been widely discussed in the media, is that unlike traditional corporate default protection, where the purchaser of protection gets paid a certain sum in the event of default, a U.S. default will likely lead to a capital markets shut down and any contractual relationships (such as credit default swaps) will likely have no value. As such purchasing US CDS is a dead end trade, with traders only betting on intraday or short-term gyrations they can trade in and out of, as other measures of expressing risk have collapsed. A good example is the drop in Bear Stearns CDS from 800bps on the Friday before JPM and the Fed "assumed" the bank, to a level in the 200s post the news. And as traders observe more and more sectors that are exhibiting increasing secular risk (i.e., homebuilders and REITs) they are concerned with purchasing outright protection in these names based on the fear that the administration may one day decide that Hovnanian or Boston Properties is the next too big to fail company, thereby collapsing CDS levels to an artificially and taxpayer-subsidized tight level.

This phenomenon is rapidly becoming global among developed countries, as sovereign spreads around the world bounce, leading to some peculiar side effects such as sovereign basis trades (where the CDS leg of a basis trade is the risk of the domicile country itself). But where does trade stack up on a relative basis?

Curiously, if one plots the ratio of Bank Liabilities as a % of a given sovereign's GDP to the CDS spread of that nation, an interesting trend emerges. As Kyle Bass pointed out, even with the recent dramatic widening in US CDS, the United States is the least troubled when observed via this type of relative risk analysis.



It seems that the market is yet again truly efficient, as it attributes by far the least relative risk to the United States (at least based on this metric). Not surprisingly, some countries which seem to have largely mispriced sovereign risk are France, Switzerland and Germany. At the moment when the levee breaks (in keeping with Kyle Bass' thinking), and the countries whose GDP simply can not sustain the debt load of their bank liabilities either through implicit guarantees or otherwise, the CDS spreads on some of the countries in the right side of the chart are likely to see substantial movement wider.

But, as pointed out earlier, the sovereign CDS trade is a dead end one, which presents the conclusion that market participants who want to express their appreciation of risk, either at the corporate or sovereign level, are likely more confused now than ever, in part due to the administration's constantly changing policy response to the deepening crisis and in part, in a modernist and inverted version of Pascal's wager, because, if ultimately proven correct, the result would be a financial armageddon which would render the instruments of expressing risk, among most other things, utterly worthless. Sphere: Related Content
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17 comments:

James said...

How does this square with the belief that some bondholders are going to take a haircut?

Tyler Durden said...

apples and oranges. we are talking wholesale risk migration. haircuts have to do with the reconciliation of declining assets and still huge liabilities at the corporate level (mostly of financials)

James said...

Its just incredible how stupid our policy makers are. Bernanke seems like he has the brainpower somewhere between a chimp and a monkey. There is no doubt we will have the same sluggish economy two years from now and an even bigger debt burden to deal with

George said...

The assumption of sovereign CDS being used to hedge default risk was being refuted this morning by the author of the blog Economics of Contempt. He was responding to the recent Krugman post on the subject (http://krugman.blogs.nytimes.com/2009/03/10/credit-protection-madness/)

From Econ of Contempt:

"Oh my god, repeat after me: CDS on U.S. government debt are spread products. Protection buyers aren't hedging default risk, they're hedging spread risk. For example, a bank that has a large inventory of Treasuries will want to hedge the risk of a significant deterioration in the value of Treasuries. Since standard CDS provide for daily collateral posting based on the value of the underlying reference obligation(s), protection sellers in CDS on U.S. government debt have to post more collateral when the value of Treasuries declines."

Source: http://economicsofcontempt.blogspot.com/2009/03/default-risk-vs-spread-risk.html

So I guess his point is that whether there is payout at the end of the day when the US goes bust is a moot point.


Just a different angle...

Thoughts?

Tyler Durden said...

very valid point and provides further incentives to game the short-term sov cds market as noted.

Jon said...

So, if wholesale quantities of risk are now borne by sovereigns, then that could mean either the financial's PE's should be higher (all other things equal) because their involvement really HAS reduced risk or the recent pop in PE's is misguided taking into account the inability of sovereigns to really do anything of real value to stem the collapse of one or more too-big-to-fails... Should we gamble on success of financials because their failure means no profit opportunity...anywhere?

Tyler Durden said...

good question. wish i knew the answer

Anonymous said...

I would still like to know how a country like the US with a floating exchange rate, no sovereign debt denominated in a foreign currency, and an independent central bank is at risk of a sovereign default. Let's say a US Treasury bond is about to mature and payment of principal requires the successful issuance of a new Treasury. If the auction were at risk of failing, the Fed would step in to make sure the auction cleared, exchanging cash for new Treasury debt with the US Treasury. Taken to its logical limit, the printing press could be used to fuel government spending that would inflate GDP and reduce the ratio of bank debt to GDP. Would anyone argue that such an outcome -- which would reduce bank debt relative to GDP -- lowers the risk of sovereign default?

James said...

Just my opninion, but I think its the later. There may not be any solution to the proble. One morning wakes up and realizes that nothing on the computer screen has any real value.

Allen C said...

A trade or hedge on US sovereign is silly. When you control the fiat money that denominates your debt, default is essentially impossible.

S said...

Anonymous said...

Two words --> dollar collapse

If what you says is so obvious and easy --> then wouldn't everyone just monotize their debt via Zimbabwe. Technical default and defacto default are different. You argue technicalities. The market differentiates. As for US being rpiced right and Germany no, one wonders. Germany may be in dire shape but they have an institution that has played with the fire of inflation and has all but annoucned it will not get inot the Bernanke TNT sandbox.

Also, it would be more constructive to discuss bank liabilities and servicability in the context of confidence. Deposits are ~50% of liabilities and as many sages have argued as long as people don't pull their money out the long slow road to recap can occur.

Look at what is happening in Swiss. The banks balance sheets are a multiple of GDP. And their seems to be a concerted attack on the financial system with the great irony it is being orchestrated by the US/UK.

In the land of the blind the one eyed man is king - destroy confidence in others to prop yourself up. that seems to be the US strategy in a nutshell. The market still gets to vote

Paul Amery said...

It's quite feasible that default could occur in a country which has its own currency. In fact it's happened regularly in history. See Reinhart, Rogoff, "The Forgotten History of Domestic Debt". In fact, if you think about it, assuming that domestic debt default is impossible requires some implausible assumptions - not least that the entity responsible for money printing is always perfectly positioned to take up the demand at bond auctions, for example. I also disagree with the argument that a sovereign (eg US) CDS could not be paid out on in the case of default. What about one priced in Euros, settled in eurozone banks? Or in roubles, settled in Russia? Or in gold? etc. etc.

Advant Guard said...

It is true that the Federal Reserve can create sufficient dollars to meet any financing need of the U.S. government, but will it? There is a political cost to financing through monetization (rising inflation) and there is a political cost to defaulting on the debt (high now because the majority of debt is owed to Americans.)

Anonymous said...

tHE EXTREME MIS PRICING IN SOME LARGE CREDIT DEFAULT SWAPS SHOULD LEAD TO THEIR EXTINCTION.sOCIETY DOES NOT NEED ANY MORE FINACIAL INSRUMENTS WHICH ALOW A VERY FEW TO GAMBLE HUGE SUMS

garyj said...

The majority on financial products and non-deliverable indices - period. Indices go up and indices go down - the game being played as always is to play the current market theme best.

The majority of daily price action in the world - shares, bonds etc occurs for this reason and this is the reason alone.

Get over it - share prices in all sorts of companies move by 10% when nothing has been annouced but some (the weight of money) perceives there to be a change. As I said indices go up and indices go down - physical delivery just like reality may occur at some future time. But by then who cares?

Nikolay said...

Looking at the comp with major EM countries (Russia, Brazil and Turkey), Bank liabilities are less than 100% and the ratio less than 0.5x.

Anonymous said...

What do you make of the fact that EM economies have much lower leverage (much less than 100% of GDP), but Liab/CDS ratio is below 0.5x?