The Wall Street Journal
FEBRUARY 5, 2010
by Gregory Zuckerman
Countries have dealt with debt woes before.
But the latest fears about government debt now riling some European markets are being fueled by a relatively new trading tool that lets investors bet against nations’ bonds.
Credit-default swaps, or CDS, enable investors to protect themselves from a default of the debt of a range of nations or wager on the likelihood of such a scenario.
In recent weeks, prices for CDS contracts have soared as investors snapped them up on worries about the bulging debt of nations including Spain, Portugal, Greece and Latvia. The CDS moves—highly visible and widely watched—have compounded the angst of stock and bond investors, analysts say, helping to pressure global markets.
On Thursday, the cost of CDS contracts that insure the debt of a number of euro-zone members with large budget deficits rose again. The annual cost of insuring €10 million ($13.9 million) of Greek government debt against default for five years rose €26,000 to €423,000 Thursday. Stocks fell sharply in Europe and the U.S.
CDS are contracts that serve as insurance on all kinds of debt. With sovereign debt, if a nation defaults the CDS buyer would get paid by the seller of the CDS insurance. Though government defaults are rare, the value of CDS contracts rise and fall to reflect investors’ outlook on the bonds they are designed to insure.
The market for CDS has boomed in recent years. Seven years ago, there was less than $3 trillion of CDS contracts outstanding; today there are more than $25 trillion of these contracts, according to the International Swaps and Derivatives Association. When prices for CDS on the debt of firms like American International Group Inc. and Lehman Brothers Holdings Inc. soared in 2008, investors interpreted the moves as signals of troubles ahead.
Now the same is happening with CDS prices rise for a variety of nations, marking one of the first potential government-debt crises in which CDS contracts are helping to spread unease. That is creating another real-time measure of investor worries—a barometer that itself can generate more anxiety.
“It’s easier to buy protection and transact a ‘short’ position, that’s half the reason CDS were developed, so people can hedge risk,” says Tim Backshall, chief strategist at Credit Derivatives Research, an independent research firm in New York. “You can move [other markets] with those trades.”
It has always been possible to sell short—or bet against—government bonds directly. But investors say buying CDS can be an easier way for them to quickly enter a wager.
For one thing, CDS can be purchased by investors who don’t own the underlying debt but want to wager that it is likely to weaken, meaning they can be bought not only by people hedging other bets but also by investors making straight wagers.
And a CDS buyer usually doesn’t have to produce as much collateral to make a bearish trade as the investor would to make a similar wager in the government-bond market. For example, some dealers allow an investor to bet against $10 million of Greece’s debt by putting up as little as $2 million and then make quarterly payments of about $105,000. If the same investor wanted to short Greece’s government debt, or borrow and sell it hoping for a drop in price, the investor might have to place as much as $10 million into an account with a brokerage firm.
Some have criticized CDS as a sentiment indicator, noting the swaps sometimes suggest that countries are headed for a default though yields on bonds issued by those countries don’t indicate such a dire outcome. They also don’t always see heavy trading, opening the door to potentially sharp price moves.
“The CDS market is reflecting where dealers are willing to make a market,” says Matt Luckett, a partner at Balestra Capital, a hedge fund that has purchased CDS contracts that protect a range of government debt. “When dealers run out of sellers” of CDS, prices can move sharply simply for lack of supply.
Some analysts say the CDS market shouldn’t shoulder blame for the market turbulence. Just as some financial companies attracted short sellers in 2008 as they faced serious problems, nations such as Greece, Spain and Portugal have piled on debt and have yet to convince investors that they will put their fiscal houses in order. That is the underlying reason for the troubles, not the trading in CDS, some say.
And for some nations, such as Greece, government bonds actually moved more than CDS prices in recent months, suggesting that CDS trading provided reassurance to the market, rather than concern. In recent days, though, the trend has reversed.
“Blaming the problems on the CDS market appeals to the populist in everyone, but in this case it’s hard to argue with the deteriorating fundamentals,” says Mr. Backshall.
Write to Gregory Zuckerman at email@example.com