Credit default swap market targets top-rated France
15 Aug 2011
In the wake of the unprecedented downgrade of its creditworthiness by Standard & Poor’s, the US five-year credit default swap price in the middle of last week was at around 55 basis points.
That of France, which is still deemed triple-A by the three main rating agencies, was much, much wider at 175bps. This makes little sense.
Closer examination of sovereign CDS prices over the past week or two reveals more discrepancies. The US CDS price at the close on August 5, just before the downgrade was announced, was 57bps.
By the close on August 8, after a day in which the wider markets had wasted no time in reacting with shock and horror to the downgrade, the CDS price was unmoved.
In fact, the US CDS price has scarcely budged over the past two months. Levels have inched wider over the year from the high 30s to current levels, but even in January there were trades as high as 50bps.
French sovereign prices, however, have ballooned wider in a very short time. They are 75bps wider over the past month, and 100bps wider in roughly seven weeks.
All of which would seem to indicate that the market doesn’t care about the US downgrade, and regards France as more likely to default even though it has held on to its coveted triple-A status. Though this assessment is not completely wide of the mark, it conceals some technical factors.
It must be noted that the market is operating in generally illiquid August holiday mode, when price movements can be exaggerated. One or two counterparties with sizeable positions can punt prices about more easily than would be the case in more liquid trading conditions.
The downgrade to the US has also been on the cards for several weeks. S&P assigned a negative outlook to the sovereign in April, and has been fairly clear about the sort of cuts in the budget deficit it needed to see were the US to avoid a downgrade.
In the event, the last-minute agreement signed by Congress just before the August 2 deadline promises a reduction of expenditure of $2.4 trillion over 10 years, less than
what was required, and S&P is pretty dubious that even this will be attained.
A credit analyst said last week: “S&P telegraphed it. They set up the criteria and, despite political pressure, they stuck to their guns.”
Although the rating agency got its sums wrong in the calculations that accompanied the downgrade statement, it does not alter the fact that the US has yet to produce a
credible plan for reducing the deficit and S&P had previously underlined the fact that this was what it needed to see to forestall a downgrade.
Ever since a US downgrade has looked on the cards – for the past two or three months – hedge funds have been buying credit protection on the US, driving the spread wider. This was not because these buyers thought the US would default or that there would be a credit event of any kind, but done purely to take profit on spread widening.
The five-year spread was pushed out from the 20s to a high of about 55bps over this period, peaking just after the downgrade, before narrowing sharply as fast-money accounts took their profits.
The price action in the one-year CDS spread, which is more liquid and sensitive to short-term events, shows this even more clearly. The one-year market was pushed out from 40bps to 80bps over two months or so just before the downgrade, but then, remarkably, after the downgrade, retreated to 40bps as profits were booked. As soon as spreads started to look as if they had peaked, protection sellers sailed into the market in a wave so as not to miss the boat.
It needs to be added that this price action was driven by a relatively small number of hedge funds dealing in large size. Another CDS analyst noted last week: “If you’ve only got 40bps to play with, then you’ve got to do it in size.”
France represents a very different kettle of fish. It has a debt-to-GDP ratio of 83%, which is high, but it is the possibility that this ratio will push to much wider levels if France and Germany have to bail out the eurozone that is disquieting the CDS market. As concern over Italy and Spain has increased in recent weeks, French prices have galloped wider in tandem.
Every plan to save the eurozone so far outlined by the eurocrats has been met by scarcely concealed derision by the market. It looks increasingly likely that, if the single currency project – into which so much political energy and so many dreams have been sunk in the past 50 years or more – is to be preserved, then the two original architects of the scheme must bankroll it.
Moreover, French banks, which are heavily exposed to Greek sovereign debt, are increasingly under pressure. In the middle of last week, it was rumoured that Societe Generale faced hitherto undisclosed and damaging exposures – which was categorically and vigorously denied by the bank.
Its stock dived last Wednesday, while the five-year CDS price soared wider by 60bps to close at 333bps – about 180bps wider than it was a month ago.
Crédit Agricole has widened by 100bps to 284bps in the first seven trading sessions of August. BNP Paribas has widened by 80bps to 230bps in the same period.
Such moves led France, along with certain other European countries, to impose a fresh ban on short-selling of financial stocks for 15 days last Thursday.
The action is designed to prevent panic. What is still unclear is what happens to bank CDS spreads when the ban is lifted.