The International Swaps and Derivatives Association’s 26th annual meeting was, by most accounts, a great success. There were good reasons for the bullishness.
For one thing, there were more delegates in Prague – more than 900 – than ever. Not bad for a market sector often thought to have its best days behind it. The organisation also had the opportunity to underline the contribution the industry had made to the creation of safe, efficient over-the-counter derivatives markets.
For example, Isda announced that more than 40% of the global interest rate swaps market is now cleared, while clearing and portfolio compression have reduced notional outstanding volumes of credit default swaps by 75%. Isda makes much of these kinds of achievement: they underscore the way in which it wants to be seen by the outside world and, more particularly, by regulators.
One might have thought that Isda’s real purpose was to get the best possible deal out of lawyers, politicians and regulators for its already very profitable members and to trumpet generally the derivatives industry’s successes, but this would be both incorrect and unfair, it seems. The facilitation of safe, efficient markets appears to be its real raison d’être.
Indeed, such is its commitment that the mantra “safe, efficient markets” can be found alongside the Isda logo on press releases and on its website. To leave no doubt in the matter, the rolling strap “for over 25 years Isda has worked to help make the over-the-counter derivatives markets safe and efficient” can be found on the same site. Gary Gensler, head of the Commodities Futures and Trading Commission, and others like him must be very glad to have such a powerful ally.
Of course, this squeaky clean stance has been forced on Isda by the events of the last three and a half years. It wasn’t so meek and mild in the bad old days. Then it would unashamedly boast of each fresh trillion or so of notional principal outstanding recorded each quarter in the markets it represents. Now, in a neat volte-face, it is eager to show how much notional principal outstanding has been diminished by compression and netting.
Shouted from the rooftops
At the end of the second half of 2007, for example, outstanding CDS stood at over $62 trillion, almost double what it had been only 12 months before, a figure that was shouted from the rooftops at the time. Yet, in these hair-shirt, post-crisis times, the new notional outstanding recorded at the end of last year of just $25.5 trillion was an equal source of pride.
The derivatives industry perhaps feels a little vulnerable about CDS at the moment, at least in public. In private, it is more bullish about an instrument that is flexible and responsive, before whose advent there was no means of taking unfunded, synthetic exposure to credit.
Moreover, CDS continue to call the market right. Over the last year or more, default prices have offered a consistently better guide to the likely default of major sovereigns than that provided by the statements of eurozone regulators.
In the 12 months since the Greek bailout package – which was specifically designed to avoid a debt restructuring – Greek CDS levels have remained stubbornly high and at default levels. Over the past few weeks they have risen from around 1000 basis points to 1400bp last week – indicating that restructuring is now largely a foregone conclusion. Current prices now suggest a 66% chance of restructuring in the next five years.
A glance at the front end of the curve is even more instructive. The credit curve is sharply inverted, with one-year prices all the way up to 1870bp, some 600bp wider than two weeks ago. Two-year prices are almost as exalted: they are at 1820bp, compared with 1290bp two weeks ago.
This means that the market believes that it is an iron-clad certainty that restructuring will occur in the next couple of years, probably sooner rather than later. Despite continuing protestations from the Greek government that this is unthinkable, leading eurozone economists and politicians now agree with the market.
Last Tuesday, Lars Feld, a member of the German government’s council of economic advisers, said: “Greece should restructure sooner than later.” In the previous week, Wolfgang Schäuble, Angela Merkel’s minister of finance, said something similar. The CDS market was right all along.
Restructuring
Meanwhile, five-year default levels for Portugal and Ireland are around 680bp to 690bp and keep on rising, suggesting that there is an increasing chance of restructuring by these borrowers as well. Ireland has been in this territory for some time, but Portugal has ticked up from around 400bp at the beginning of February. According to credit analysts, the widening in Greece, Portugal and Ireland shows no sign of abating.
If the CDS market is right – and it has been so often in the past – then a restructuring of Greek debt is a done deal and it is becoming increasingly likely for Portugal and Ireland. French and Swiss banks bear a reported €79bn exposure to Greece, with BNP Paribas the worst affected of the French banks. It is in the hole for €5bn if Greece goes under.
At the last count, five-year default swap prices for BNP Paribas were 100bp, 14bp wider than two weeks ago, while Societe Generale – another bank heavily exposed to Greece – has widened from 110bp to 124bp in the same period.
Indices and single-name prices tell us a lot about the way the market is heading, and investors would be advised to look at them more closely than at comments by finance ministers. The CDS market is not only a valuable hedging tool but a key and perhaps unrivalled gauge of market sentiment. It has made a tremendous contribution to the disintermediation of risk. Isda probably knows this but doesn’t want to make a big deal out of it. For the time being, it is safer to go on about safe and efficient markets – at least in public.