CDS

Creditex has just reported the preliminary results in the CDS settlement auction of Allied Irish Banks. According to initial data submitted to ISDA (for more on the mechanics of CDS auctions read here) on behalf of buyers and sellers of CDS into the auction, the AIB senior bonds will see a final recovery value of about 71.375 while the sub will barely recover 10%, or 12 cents on the dollar to be precise. Alas this is likely indicative of market clearing levels on most European bank bond liabilities due to the incestuous circular nature of European bank assets and liabilities where everything is interconnected in one massive closed loop. And yes, one wonders just which regulating central bank allowed this bank's debt to be pledged as collateral for as long as it did.

A comparison between equity and Subordinated CDS (inverted scale) levels on STD (that would be Spanish mega bank Santander) indicates that while stocks are still balls to the wall in hopium, credit is getting far more concerned about both recovery and viability prospects of the bank which is considered by many as the gateway to a full blown Spanish sovereign funding crisis. Where STD goes, so goes Spain. And the last time we checked, equities were right at the expense of credit... never. Is it time to just say not to STD? The CDS certainly says so.

In the past few days reporters from Bloomberg, Reuters, and the FT have all basically said the spread is a per annum fee to insure against Greek default. That is not actually correct. If someone buys 10 million of 5 year Greek CDS at 2000 they do NOT pay 2 million per annum until the maturity or a Credit Event occurs. They pay 500,000 annually, quarterly in arrears until the scheduled maturity date or a Credit Event occurs, AND they pay 3,662,325 up front. This is a big distinction. It is true for all CDS. The quoted running spread is converted to an upfront payment based on an actual running spread of either 100 bps or 500 bps depending on the name. Certainly for tight names, this difference is more of a technicality, but for distressed names it is meaningful.

Now that the Greek bailout is topic front and center for the second year
in a row, it means that it is time for the mainstream media to once
again prove to the world that in the past year it has learned precisely didley squat about
how the more complicated securities used in capital markets operate.
Such as CDS. Just like in May 2010, the prevalent trope among the clickbaiters
is that CDS written against Greece will destroy the world, in
superficial attempts to bring about panic induced by the faulty
conventional wisdom that CDS was the cause for the implosion of AIG.
Well, wrong.

About the only thing that the doom and gloom crowd, the politicians, and the media all agree on is that credit derivatives are evil, unnecessary, ‘financial weapons of mass destruction’. With the European Sovereign Debt crisis escalating, the CDS market has once again become a topic of conversation. Many of the issues related to CDS that are discussed are old, misleading, or plain wrong. Here is my attempt to address some of the issues that come up most whenever CDS is mentioned: Credit Events; Exposures; Counterparty Risk, and Transparency. These are topics that need to be understood in order for investors to make informed decisions. I am not here to defend CDS as a product, but to try and shed light on the subject so that people don’t react to inaccuracies that cause them to make decisions based on incorrect information. Since so many journalists still feel that the investing public needs to see the boilerplate language ‘when yields go up, bonds prices, which move in the opposite direction, go up’ this may be an uphill struggle. But here is my attempt.

That Greek CDS just hit the now meaningless level of 2,050 bps or up 280 bps for the day is now longer relevant: the Greece default is now fully priced in. What however has yet to be priced in is what will happen to liquidity when this now inevitable event does occur. To say that the impact on stocks and the EUR would be disastrous is an understatement. So while stocks are enjoying the worst two day pair of news in years by surging on expectations of yet another Chinese bailout of Greece (because the first two worked so great), here is a snapshot of the FRA-OIS spread we discussed yesterday, and which today hit a 2011 high of 34, since declining modestly to 28. Unless something totally unprecedented appears and manages to once again delay fears of a Greek bankruptcy for another 6 months, this spread will continue making overnight funding for European, and soon US, banks, rather problematic.

This morning Greek CDS is trading at a spread of 1,900 bps: a level that seals the fate of Greece, whose bonds are being sold into a bidless market. Two primary factors have totally shocked the market: one is that, as Reuters, reports, Germany now "wants the deadline for for a second
Greek rescue package to be pushed back to September, reflecting the
problems Europe is having hammering out the details, EU and banking
sources said on Thursday." This means that Greece may well run out of cash in the interim, but it appears that Germany is now fine with that outcome. The other news comes from Athensnews.gr which reports that the exodus of MPs from ruling PASOK is now picking up: 'Ruling Pasok MP Yiorgos Floridis on Thursday tendered his resignation, the second ruling party MP to resign in the space of two days, followed by Ectoras Nasiokas, Larisa Pasok MP. George Lianis was the first Pasok MP to resign on Tuesday afternoon. In addition, veteran Pasok MP and former minister Vasso Papandreou asks for an extraordinary meeting of Pasok parliamentary group. Floridis resigned from his MP post, but did not declare himself an Independent, thus in effect "returning" the seat to Pasok." With the PASOK already slender majority in parliament in its current formation, these ongoing defections mean that, just as we warned, the mid-term fiscal proposal will likely fail in parliament and Greece will do what Ireland should have done, and what in fact Greece should have done a year ago, and voluntarily leave the eurozone. It also means that keep a close eye on the FRA-OIS and Libor-OIS spreads as today all liquidity hell can break loose now that a break up of the eurozone appears certain.

Good morning Europe: do you know where you record wide PIIGS CDS are? From Reuters: "The cost of insuring Greek government debt against default rose to a record high of 1,600 basis points on Monday, hit by concerns that any second rescue of Greece will trigger a credit event or at least multi-notch rating downgrade of its debt. Five-year credit default swaps (CDS) on Greek government debt rose 58 bps on the day to 1,600 bps, according to data monitor Markit.  The Markit iTraxx index of western European sovereign CDS was up 9 bps on the day at 220 bps, near a record high of 221 bps hit on January 10. Portuguese CDS were up 40 bps at 773 bps, while Irish CDS were 33 bps higher at 745 bps, both at record highs. Spanish CDS were up 13 bps at 289 bps." The slow motion European implosion is now accelerating as the reality that there is no spoon, nor rescue plan, is finally appreciated.

Nobody could have seen this coming. According to RanSquawk, there is "Market talk that accord on new Greek bailout faces major obstacles." Whether true or not is irrelevant: the market sells first. Greek CDS just hit 1,474, +63 bps and an all time record high. Elsewhere, the EURUSD is dropping as the house of cards appears to be finally on the edge. Per Market News: "Despite public declarations last Friday that an agreement in principle had been reached, two major problems threaten to block a deal, the sources said. One is the highly sensitive issue of private sector contribution. The other is the insistence of European officials and the International Monetary Fund that the Greek parliament pass significant new deficit-cutting measures before EU leaders meet at the end of June as a condition for new money. That task appears Herculean, given the rapidly growing domestic political and social resistance. "

The latest "Risk Off" CDS rerack on European sovereigns courtesy of CMA. Needless to say, all wider.

The Greek CDS market is actually fairly small. According to DTCC, there is only 3.8 billion euro of net CDS exposure on the Hellenic Republic. That compares to almost 300 billion euro of debt outstanding. There may be some additional exposure to Greece cds since it is included in SOVX, but the Greek portion of net SOVX exposure is very low, and some of the exposure is offset by investors who trade 'cds index arb'. Not only is the 4 billion euro of exposure relatively small, most of it is held in mark to market accounts, so a lot of the loss to the system is already accounted for. Since the net exposure is small, banks are likely beneficiaries of a credit event, and markets will see through this feeble attempt at avoiding the stigma of a default, the EU finance ministers should stop worrying about how a restructuring will impact CDS. They should focus on restructuring in a way that provides the best possible outcome for Greece and creditors and not worry about what happens in the CDS market as a result. If after sorting out the Greek situation, they still have time to think about CDS, they should spend that time figuring out who sold the protection and why? For every evil, vile, nasty, hedge fund who had bought credit protection, someone took they other side and sold protection? If the purchasers are so evil, does that make the sellers angelic?

Following last week's news that as we suggested US stagflation is starting to shift to China, SocGen's Patrick Legland looks at the consequences of what a Chinese slowdown in H2 would look like for the country, and the world. Cutting to the chase: buy Chinese CDS, and sell hard commodities. That said, the risks to the global economy, should China implode, are far vaster, and we fail to conceive how the central planning cartel would ever allow this to happen, or the PBoC for that matter, considering today's earlier news of not one but two failed Chinese auctions.

Earlier we observed the long-overdue (noted first here in March of 2009) allegations that Markit among any others may be involved in a massive CDS pricing collusion scheme. Now it is Markit's turn to provide its side of the story.

Back in March of 2009 Zero Hedge, once again a little conspiratorially ahead of its time, solicited reader feedback on a key topic: CDS pricing manipulation, involving in addition to key cartel banks, such "independent" pricing services as MarkIt. We said: "Zero Hedge has received some troubling info (like there isn't enough)
regarding major pricing discrepancies between certain securities pricing
services. The services include companies such as IDC, Advantage Data,
Markit and others. While I will not disclose which one may be a culprit,
the allegation is that one (or more) are providing substantially above
market pricing levels, specifically as pertains to distressed
securities." Then back in August 2010, we followed up by explaining that it is the ongoing price manipulation scheme, in addition to other factors, that allows Goldman Sachs (and other CDS dealers to a much lesser extent) to constantly generate massive profits from trading an opaque off-exchange product like CDS. It took two years and a month for others to take notice of this inquiry, although naturally not in that slum of corruption and market manipulation, the United States of America, but in Europe. Bloomberg reports: "Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. (JPM) and other 14 other investment banks face a European Union antitrust probe into credit-default swaps for companies and sovereign debt, regulators said. ...The European Commission said it opened two antitrust probes. It will check whether 16 bank dealers colluded by giving market information to Markit, a financial information provider." So while some post flow charts explaining the hilarity behind conspiracy theories, others actually expose the facts that today are a conspiracy and tomorrow are a full blown criminal investigation.

Exactly a year ago, Zero Hedge penned "The Client Always Comes First At Goldman... Except When He Doesn't, Which Is Also Always" which was a review of Goldman's mark manipulation practices particularly as pertains to the OTC domain (read CDS) by going through self-evaluation reviews of the 4 key Goldman trades involved in the Abacus scandal (we would call it crime, but remember: Goldman neither admitted nor denied guilt). As a reminder, in April 2010 we said: "The line penned by Michael, who incidentally was the least like of the
three Goldman SPG MDs testifying on Tuesday based on peer feedback, that
broke our collective heart is the following: "Once the stress in the
mortgage market started filtering into the cash market, I spent numerous
hours on conference calls with clients discussing valuation
methodologies for GS issued transactions in the subprime and second lien
space [redacted] is prime example). I said "no" to clients who demanded that GS should "support the GSAMP" program as clients tried to gain leverage over us. Those were unpopular decisions but they saved the firm hundreds of millions of dollars." Alas, we find that all of Goldman's sincere hypocritical lies before the Senate committee were... precisely just that." This post was followed up by "Goldman Implicated In CDS Price Manipulation Scandal" which essentially recapitulated all the salient points from the first time. Today, with about a full year delay, Bloomberg's Christine Harper and Joshua Gallu realize that there was more than meets the eye to these very disingenuous revalations of impropriety by the very traders who were conducting them, and finally bring much needed broader attention to the matter in "Goldman Traders Attempted to Manipulate Market in 2007, Senate Report Says." Frankly, it's about time.