Cantillon

Inside the world of business

More credit due to banking system

THE PARADOX that is the credit default swaps market was on display once again yesterday.

At one level the system seems to be working as planned. The International Swaps and Derivatives Association said that the Government’s restructuring of Irish Life Permanent constituted a “restructuring credit event” that might trigger CDSs linked to the group that investors had ostensibly bought as insurance against a default. Some €276.8 million will be paid out according to Depository Trust Clearing Corporation.

This is how CDSs are supposed to work. They make the market more efficient by dampening the often traumatic spillover effects of corporate or sovereign defaults.

But the extent to which they are having the opposite effect was also evident yesterday when the German government resurrected its plans to get Greek bondholders to extend their loans.

This idea was floated earlier in the year but fell out of favour because, amongst other reasons, it would be treated as a default by rating agencies and thus trigger Greek CDSs.

The paralysing fear here is that the banks that wrote these CDSs simply are not good for them and if they were called in, it could spark a crisis comparable to that which followed the collapse of Lehman Brothers.

A big part of the problem is that many of the CDSs are naked – ie not actually linked to a specific bond holding. This is contrary to the basic notion of insurance and means that many CDSs and are in fact just another form of highly leveraged speculative investment.

Instead of being part of the solution, sovereign CDSs have become part of the problem, actually proving a impediment to letting events taking their necessary course. In this case default by Greece.

The good news – if that is the word – is that the Germans reckon the systemic risk associated with the €4-5 billion of outstanding Greek CDSs is “limited but not negligible”.

This translates as meaning that the insurance policies that banks were allowed to sell to make defaults more digestible by the global financial markets, might not actually collapse the global banking system on this occasion. Bravo.

Ireland and Portugal playing bailout tag

GREECE’S SOVEREIGN debt was downgraded to junk status long ago. Portugal got junked on Tuesday night by Moody’s, one of the big-three credit ratings agencies.

For good measure, its analysts suggested that the Iberian state might need a second bailout.

The PIIGS (Portugal, Ireland, Italy, Greece and Spain) have been on the slide since the euro area sovereign debt crisis began last year. The pace of slippage has varied and the lead in the race to bottom has changed back and forth.

Last summer, yields on Irish and Portuguese government debt mirrored each other. But as confidence in Ireland began to evaporate in August, they decoupled. A pre-emptive bailout followed in short order.

While both states’ sovereign bond yields have gone on rising relentlessly, the gap had been narrowing up to Tuesday. Yields in the market for our old friends, credit default swaps, saw Portugal overtaking Ireland in perceived riskiness in recent weeks.

The speed of Portugal’s slide is likely to have spooked Moody’s into downgrading its debt.

Yesterday, in reaction to the downgrade, yields on all Portuguese sovereign debt instruments exploded. Ireland suffered contagion. Irish government debt and the CDS yield spreads reached yet another crisis peak.

The State’s credit rating has not yet hit junk status. But it won’t be long. Ireland dragged Portugal to its first bailout.

Portugal may drag Ireland to junkdom, and a second bailout.

TODAY

All eyes will be on the European Central Bank, which is expected to raise interest rates, thus creating fresh headaches for Irish mortgage-holders.

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