S&P: United States Safe... In Near Term

The good news:

Currently, 17 of the 124 sovereigns we rate have 'AAA' long-term ratings and stable outlooks. These include close G7 peers, such as Canada, France, and Germany.

We believe the U.S.'s key credit strengths include:

-- A high-income, highly diversified economy, with unusually flexible labor and product markets.
-- The unique advantages associated with the U.S. dollar's preeminent role as the world's most used currency (see "Despite Pressures, The U.S. Dollar Remains The Key International Currency," published Oct. 15, 2007, on RatingsDirect).
-- The country's openness to trade and capital flows and experience in adapting to associated fluctuations.
-- The country's stable political system with strong, long-established institutions, its ability to respond to changing economic and financial circumstances, and its transparency in policymaking.

[The] key international role of the U.S. dollar gives the U.S. government substantially greater fiscal flexibility than the U.K. government, owing to the more modest global role of the U.K. pound sterling. We believe this flexibility would even enable the U.S. general government to carry debt in excess of annual GDP without a widening of credit risk premiums in its borrowing costs, as long as the market viewed its plan for fiscal consolidation as credible. [so as long as the US holds the dollar as its currency, there will be no downgrade? even if debt/GDP goes higher than 100%?]

The bad news:

We believe the U.S. shares some credit characteristics with the U.K., the outlook on which we recently revised to negative (see "United Kingdom Outlook Revised To Negative On Deteriorating Public Finances; ‘AAA/A-1+’ Ratings Affirmed," May 21, 2009, on RatingsDirect). We project that the cost of recapitalizing the financial system will be higher in the U.S. than the U.K. (10%-20% of GDP for the U.S. versus 7%-10% of GDP for the U.K.) and that both countries will endure a period of subpar growth as the private sector deleverages.

We believe that fiscal pressures in the U.S. are, in relation to GDP, the highest since World War II and, absent steps by the government to counter them, would likely persist over the longer term. Consistent with our sovereign ratings criteria, we focus on the general government fiscal balance and the trend in net general government debt, two measures that consolidate the operations of local, state, and federal governments. However, most of the fiscal deterioration we expect in both the near term and the longer term is in the budget of the federal U.S. government. In the U.S. government's own words, increasing health costs and the aging of the population will place the budget on an unsustainable course without changes in policy to address these challenges. Recent projections by the Office of Management and Budget show deficits remaining at high levels, in comparison to the past 15 years, for the next 10 years.

So S&P is essentially saying absent a default or full debt monetization, AAA is merited... Or did we read that wrong? Sphere: Related Content

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The IMF On Risk-Free Assets, Sovereign CDS and VIX

Publish at Scribd or explore others: School Work Business & Economics Non-fiction 2008 world

hat tip Alex Sphere: Related Content

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S&P: U.K.Outlook Revised To Negative

The sovereign downgrade monster is back on the rampage. Earlier today, S&P fired a blank shell straight at the heart of the usurper formerly known as the developed world, when it put UK's credit outlook on negative. The premise: debt/GDP will soon pass 100%. In that case the US should be afraid, very afraid with some estimates for the comparable ratio in the United Printing Presses of America at over 370% (including the kitchen sink).

• Standard & Poor's has revised the outlook on the United Kingdom to negative from stable.
• The 'AAA' long-term and 'A-1+' short-term sovereign credit ratings were affirmed.
• The outlook revision is based on our view that, even factoring in further fiscal tightening, the U.K.'s net general government debt burden may approach 100% of GDP and remain near that level in the medium term.

Outlook

The negative outlook reflects Standard & Poor's view that, in light of the challenges to strengthen the tax base and contain public expenditures, the U.K. government debt burden could approach 100% of GDP by 2013 and remain near that level thereafter. The rating could be lowered if we conclude that, following the election, the next government's fiscal consolidation plans are unlikely to put the U.K. debt burden on a secure downward trajectory over the medium term. Conversely, the outlook could be revised back to stable if comprehensive measures are implemented to place the public finances on a sustainable footing, or if fiscal outturns are more benign than we currently anticipate.

First Japan, now the U.K., the pattern is pretty obvious. Load up on U.S. CDS at 38 bps anyone? Sphere: Related Content

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A View On Sovereign Risk

The chart below presents the top 20 sovereigns with the largest amount of net CDS (not gross) notional outstanding. Interestingly, Italy and Spain, with their $20.4 billion and $11.1 billion in net notional, have the most net risk exposure, (General Electric, parent of brutally realistic and objective financial news station CNBC is at $11.2 billion). Additionally, the chart demonstrates not just the current spread of any given sovereign's CDS level, but also the phenomenal tightening that has occurred since March 6. What is surprising, is that as corporate risk has been socialized by sovereigns all over the world (most notably in the US), this chart indicates that "some" entity has also been socializing sovereign risk: Zero Hedge would love to know who that could be. Absent that "logical" explanation, the only other reason for the 148 bps average tightening is that trading is based exclusively on technicals (read squeeze), which is to be expected: after all technicals (and induced squeezes) are the driving force behind virtually all capital markets lately.

Cynical rationalization notwithstanding, the fact that accounts have expressed such a pervasively gloomy opinion of Italy and Spain indicates that, squeeze aside, the trouble in Europe will most likely start with these fine, Vespa/siesta loving countries. Indeed, Spain with a 17% unemployment rate, a subprime crisis that can easily hold at least 10 rounds with its US heavyweight equivalent, and the absence of a currency that would allow it to inflate itself out of its economic hole, the holders of $11.1 billion in CDS may just be on to something. As for Italy, all bets are off.



P.S. the missing country name on the chart below is Ireland. Updated for Italy as well, which was not surprisingly off the charts (literally).

Source: DTCC. Sphere: Related Content

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Who Said Logic Pays?

The attached graphs demonstrate the massive rally in Sovereign CDS over the past few weeks, as well the collapse in the divergence in the VIX - Sovereign CDS pair.

The main reason for the Sovereign move has to do with short-covering as the Sovereign vs Financials trade came undone and hurt a few people comparing Sovereign risk to the senior-sub differential in financials.



After Lehman, the trade was short sovereigns vs. long corporates OR long financial seniors as risk was pushed to the state…last few weeks have seen that get hurt post the roll as financial risk has been assumed away. The green line shows the Senior financials over sovereigns risk and how well the trade worked from Lehman to mid Feb.

Senior-Sovereigns started taking profits and with liquidity dropping, Sovereign CDS rallied well as shorts covered – the differential gapped wider and Senior-Sov positions felt the pain and rushed for exits. That helps explain the disconnect between VIX and Sovereign CDS recently.



The rally in Senior Financials has also helped some still in the Sov-Seniors trade and in recent days there seems to be some movement back into it, although this time there is likely more of a balance between Senior-Sub decompression against Sovereigns.

Alternatively, this time look for a possible reinforcement loop between VIX and Sovereign CDS levels.

Hat tip Tim B Sphere: Related Content

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More Observations: VIX - Sovereign CDS Divergence

As Zero Hedge postulated a month ago, the VIX - sovereign CDS inverse correlation is becoming more and more evident. Today's action is representative: as VIX continues to slowly trickle lower, US protection is 5 wider. With the G20 pledging trillions to battle every cough and sneeze of the markets, the question becomes what does all this mean for sovereign default risk, and thus VIX, and thus equity markets. With G7 or G20 or Gx debt soon to hit astronomical (this is a technical term) levels, how will all the interest cash flow be funded? How will skyrocketing sovereign deficits be funded? Who will keep on buying UK and German (not to mention US) debt after several failed auctions over the past 3 months?

Many questions with no answers - in the meantime, we either just crossed from deflation into inflation today (which is the most laughable thesis if one actually looks at macro data and the level of consumer wealth: for reference just dial David Rosenberg), or the market is just rallying on the biggest sucker rally in recent years with vanilla, smart, retail and all other sorts of money just hoping for the greatest greater fool effect in generations.

****Update****

Cramer just pronounced the "market depression" that started post Lehman as over. Now we are merely in a recession.

Sphere: Related Content

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Tracking The G7 Sovereign Risk

Zero Hedge has written repeatedly in the past about the importance of keeping track of sovereign CDS levels as more and more corporate risk (especially in financials) is being offloaded to the balance sheet of respective sovereign balance sheets. And while pundits may claim these indications are useless as there is no way, no how that the U.S. may ever default on its debt (empirically incorrect), they provide an indication of the commingling of risk, and every risk manager should take them into consideration when making investment decisions.

Among the prevailing market theories is that the rise in G7 CDS levels is among the main causes for the subdued levels of the VIX which, since November last year, has stopped exhibiting parabolic behavior even on dramatically down days (unable to pierce 60 in the early March market plunge, after breaching 80 when the market hit the higher lows of November 2008). A comparable theory can be applied to credit index levels such as IG11 which did not retrace its November wides by a significant margin.

A convenient way to keep track going forward will be using G7 sovereign CDS indices, which are only gradually starting emerge. Credit Derivatives Research, seeking to capitalize on this unmet informational need, has launched a government risk index which aggregates the sovereign risk of the G7 nations.



The major purpose for this index is presented by Arthur Rosenzweig, CDR president:

“Rapidly increasing budget deficits and debt levels, nationalization of large failing financial institutions, deepening recessions, disproportionate foreign holdings (e.g., by China) and loosening monetary policies have led many investors seriously to consider the possibility of a credit event by one of the major sovereign borrowers, or at least to speculate on their credit quality.”

US Treasuries are considered the “no risk” asset in many portfolios and yields on other assets are often quoted in terms of spreads against Treasuries. These securities are also the “go to” asset for banks and governments to hold as reserves. CDS on Treasuries now trade near 70 bps, up from 20 bps last fall. In other words, US sovereign CDS now trade well above where the CDS of the major banks traded at the beginning of the credit crisis two years ago. The current CDS spread levels of the other countries in the GRI are UK 115, Germany 55, France 60, Italy 145, Spain 105 and Japan 90.

As quantitative easing goes full steam over the next several months, sovereign index CDS will likely be the most efficient way to keep track of how the market evaluates the risk to and from the G7 countries, as unprecedented amounts of debt pile into the liability side of the sovereign balance sheet. Zero Hedge expects to see significant moves in sov CDS levels over the next several months, especially as the situation in Eastern and Central Europe hits an inflection point of no return. Sphere: Related Content

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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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The Inversion Of Corporate and Sovereign Risk, Or The Sovereign Basis Trade

The recent spillover of the threat of an Eastern European collapse, and its gradual spread into the Eurozone, has manifested itself best in the dramatic widening of sovereign CDS. The so-called socialization of risk had resulted in a tightening of corporate and bank default risk at the expense of the respective sovereign domiciles. Recently, however, the continued widening in sovereign risk has led to a more circular relationship with financial risk, as after the initial knee jerk reaction leading to financials being perceived less risky (or tighter) late last year, bank CDS have started moving wider yet again. And while non-financial corporates have seemed relatively insulated from a correlated move wider with sovereigns, the biggest threat of another significant risk flaring is probably concentrated the most in corporate risk. As we show below, there are many corporate CDS which trade paradoxically at levels notably tighter than their respective sovereigns, presenting an opportunity for daring investors to put on converging basis trades where a sovereign is the long-risk leg.

Why has sovereign risk skyrocketed?

As we noted last Friday, US Sovereign CDS for the first time ever passed the psychological barrier of 100 bps after trading in the 60s two months ago. The primary reason for this, at least domestically, has been the rapid increase in public sector debt to compensate for the deleveraging in the private sector. As credit risk has become more socialized in the U.S., the overall riskiness associated with leverage has shifted from the individual and corporation (which still have a lot of risk), onto the balance sheet of the sovereign.

And the U.S. is not alone, as it offloads private sector risk to its balance sheet: most foreign sovereigns are encountered with the same challenges and are responding as much as they can (many with the assistance of U.S. swap lines) by levering their own balance sheets. As the investing public has figured out this shift, trading in sovereign CDS has exploded and current outstanding gross notional and # of CDS contracts has hit record levels as seen in the table below (sourced from DTCC).

Empirically this is obvious when the historical progression of sovereign CDS trading levels is mapped out (again, the higher the number, the greater the perceived risk).

And for CDS traders out there, the structural difference between corporate and sovereign CDS, is that while both types of contracts include Failure To Pay, and Restructuring as credit events, Western European corporates account for Bankruptcy as the third gating event, while Western European sovereigns account for Repudiation/Moratorium.

Implications for non-Sovereign Risk

The two main categories here include financial companies and non-financial corporates. When the U.S. started opening up swap lines in October last year, and foreign central banks pledged huge sums to support a financial system in crisis, the immediate reaction was to bring financial risk significantly tighter. However, as the situation has not improved and more and more capital has had to be allocated in the form of senior debt guarantee programs and fiscal stimuli packages, the inverse correlation between sovereign and financial risk has disinverted, which is especially obvious over the past month, and the widening correlation has again become positive and approaching 1. All this is mapped out on the graph below: note the rapid rise in the orange line which represents the iTraxx Subordinated Financial Index over the past month, which is finally moving to catch up to the ever increasing sovereign risk.

Curiously, non-financial companies' risk has, to date, been impacted much less by deteriorating sovereign risk. The immediate explanation for this phenomenon is that while banks are again perceived as government risk, corporates are benefiting from the dramatic improvement in private capital raising in both debt and equity markets. The bottom line is that most corporates have not needed government support so far. The financial to non-financial divergence can be traced by looking at the opposite paths of the green and the orange line over the past two months in the chart below (green line represents the popular European HiVol index excluding sub financials).

One can argue that it is only a matter of time before non-financial CDS has a dramatic move wider as the weakness in both the government and the financial sector are understood to not be isolated threats. This is made much more obvious when once considers that there are numerous corporate names that have pushed tighter than their sovereign spreads! The table below lists all examples, but the biggest outliers are Telefonica whose 5 year CDS trades at 117 bps, compared to Spain at 148 bps, OTE is at 132 bps, compared to Greece at 254, Carrefour at 83 versus 91 for France, and Safeway at 55 versus 156 for the UK. Intuitively the thought experiment of having a UK sovereign default (for example) which would not implicitly or explicitly result in the bankruptcy of a company such as Safeway is unfeasible. But that's not all - the CDS to bond dislocation is evident in this love triangle as well: Tesco which also trades tighter to UK CDS (implicitly less risk than the UK), recently issued two bonds, both of which priced at 250 bps over Gilts. The confusion is complete: CDS and bonds of one and the same company imply it is both less and more risky than its sovereign!

The obvious trading implication would be to put on basis packages using the sovereign as the long-risk leg, and the corporate as the short-risk. The idea is that either corporates will quickly overtake sovereign risk as the credit markets continue thawing, or, in the worst case, will converge as default risk for the sovereign is perceived as the "lowest common denominator" below which all "less risky" names will also end up in default.

Sphere: Related Content

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