Avoiding triggering Greek sovereign CDS is a mistake

Should policymakers attempt to prevent credit default swaps?

Credit default swaps (CDS) are supposed to serve as a form of insurance against default.  A sovereign CDS provides insurance against a country defaulting.  If such insurance is not available, then companies and investors, wishing to insure themselves against the possibility of a country defaulting, will either have to reduce their exposure to such an event (eg by selling their holdings of that country’s bonds) or hedge in some other way (eg by going short on that country’s bonds).

In the run-up to the 21 per cent Greek default announced on July 21st, Eurozone policymakers were quite explicit that they would try to design the default in such a way that credit default swaps would not be triggered.  They doubtless thought this a clever wheeze, imagining it would punish those who had used CDS to speculate upon the possibility that Greece would default (how wicked of them!) and might deter others from using CDS to speculate upon Portugal or Italy defaulting.

Of course, one immediate consequence of this was that investors sold their Greek CDS.  But once the July 21st deal was announced, there were consequences for Italy, also.  Italian bond yields spiked.  Partly this was because selling Italian bonds became the key way of speculating upon total collapse of the euro.  And partly it was because if firms and investors wanted to hedge against / speculate about Italian default, they could no longer trust Italian sovereign CDS.  Net Portuguese CDS positions have fallen more than 30 per cent in recent months, and Italian net positions more than 25 per cent, despite increased perceived risk that these countries will default.  As a predictable consequence, Italian bond yields went above 6 per cent.

Following last night’s quasi-deal, the whole concept of a sovereign CDS in the Eurozone appears to be finished.  If losing even 50 per cent of your money on Greek government bonds doesn’t trigger payout on the CDS insurance you purchased, what is the point of them?  Eurozone sovereign CDS are now virtually worthless.

The question now is, once the halo of the EFSF leverage is gone, what are the implications of the death of the sovereign CDS market for Italian bond yields?  Had the larger Greek default triggered CDS payouts, one might reasonably have expected Italian bond yields to fall (at least once the initial dust had cleared), because the credibility of insurance was greater.  But what now?  Had everyone already assumed that Italian and Portuguese sovereign CDS were worthless, or were there some poor souls still hoping they might provide some protection?  If the latter, then we should expect Italian and Portuguese yields to rise (eventually), as a consequence – at least until financial markets can produce some new credible mechanism for providing insurance.

We can observe a paradox here.  In this financial crisis, governments have insisted upon destroying the functioning of capitalism by providing implicit state insurance of banks, through bailouts and debt guarantees.  At the same time, governments have sought to destroy the system of market insurance of banks (and others) that existed through the private sector – through sovereign CDS.  Dumb?  You might very well say that…