Ask Clem: If Italy goes bust, who can afford to compensate bond holders?

Clem Chambers, founder of ADFVN.com

Got an economics question? Here’s your chance to put it to one of the City’s best known characters, Clem Chambers, founder of ADFVN.com

Question for Clem:

“What is the point of sovereign Credit Default Swaps? After all, if a country like Italy or Spain defaults on its debts there is no financial body in the world which could afford tocompensate bond holders. So why do people buy them?”

Alex Barr, founder and chief executive of Basingstoke-based marketing lead generation firm Genlead

Clem answers:

‘Efficient Market Hypothesis’ refers to the idea that it’s impossible to beat the market, due to its efficiency causing share prices to always incorporate and reflect all relevant information.

It’s is a well-known theory, but one that is often attacked and ridiculed.

However, EMH is an extremely good model for the way markets work. Central to the idea, and for that matter, academic arguments against it, are probability and the maths of chance.

Financial markets are highly efficient. Private investors tend not to see it that way. They don’t buy stocks they think might fail, they don’t hedge and they very rarely ‘play the odds’.

In the professional trading world of fund management however, the picture’s not so simple. This world is one full of hedging and averages. 

In this world financial instruments – equities, options, bonds or more abstract financial contracts like CDS – a;re meant to work together as part of a package of financial positions. Some will win and some will lose.  The different instruments in the package, when combined, should provide a predictable return.

CDS fit into this universe. They are insurance policies –  ones where value changes along with conditions.

Writers of CDS will have their reasons to sell them. Buyers will have reasons to buy them. It’s unlikely either party will get involved with something set to fail further down the line. As such, the bulk of complex derivatives, like CDS, are merely a way to make the creation of money more efficient.

This money creation normally occurs by taking illiquid assets and allowing them to become liquid again, allowing a slow moving financial instrument to move faster around the system and thereby create more cash flow.

This “leveraging up” of money has gone into reverse since the credit crunch. The crunch occurred because complex financial engineering malfunctioned and has consequentially been wound down through legislation and regulation.

A sovereign CDS for Italy insures against a huge default; nearly 2 trillion euros of debt. Those writing a CDS to someone who wants this insurance is not really doing so on the basis of paying out on the total value of the sum insured. It could happen – particularly now. 

Instead, the CDS is used as a hedging instrument, which enables market participants to lock in profits or pin complicated positions to a constant value. This is the reason most CDS will have initially been created.

Of course, some have bought CDS to take a one-way bet that Italy will get in trouble. These people have done very well up until now, but originally, and in the main, CDS is not a betting instrument but a hedging instrument – like all such contracts they can be used for both.

If Italy defaulted, the CDS would pay out the sum total of the sum insured, even though a large chunk of the European financial system might implode. That is why it is essential to consider who is selling the CDS; the writer should, in a normal situation, be able to pay out but this is not a normal situation.

When an investor buys CDS in the current climate it is the strength of the bank who writes the CDS that is key. If you bought a CDS on Spain from a bank in the US and Spain that then defaulted, the chances are that the US bank would pay out the full amount because it is contracted to do so.

The fall of Spain though would not break the US bank. If it did the Federal Reserve and US government would ride to its rescue.

As such, you wouldn’t by a Spanish CDS from a Spanish bank – at least not in the current environment.

In the case of Greece, the government of Europe has fixed Greece’s default by unilaterally redefining it as a “non-default” default. The CDS trigger has not gone off because the EU regulators have in effect forced a default on the insurance itself.

When times are as tempestuous as they are today you can be right, make a huge bet that should pay out big and then still lose by being cheated.

You buy a lot of gold from a bank, gold goes up. But if the bank goes bust, you lose your gold. Many suffered this with the Lehman collapse and the recent MF global bankruptcy.

Counterparty risk is independent of sovereign default –  or at least can be. Yet it is the contagion that everyone is scared of – where a collapse in one part of the global market sends an avalanche of default across the world.

Unfortunately, in the current climate, this could be as much a danger for an old-fashioned cash deposit as for a complex Sovereign CDS.

 

Clem Chambers is the founder and chief executive of ADVFN.com, which offers stock quotes, charts, news, FOREX, futures & options and stock screeners on more than 70 stock markets worldwide. He is also the author of 101 Ways to Pick Stock Market Winners. If you’ve got a question for Clem, whether on trading, economics or business in general, email us at: [email protected]