Greek CDS drama holds lessons for investors
It’s over. The long-running drama over Greek credit default swaps finally came to end with a $2.5bn pay-out for those who had bought protection against default by Athens. Yet, while market disorder was avoided, there remain concerns that CDS are flawed.
Market participants insist lessons need to be learned from the Greek debt restructuring deal and bond exchange, or these insurance-like instruments, untested in a sovereign restructuring before Greece and which are used as a protection against losses on bonds, could lose their appeal.
An auction held by 14 banks set a market-wide payout of $2.5bn, or 78.5 per cent of the $3.2bn of net outstanding CDS as of March 9, when a so-called “credit event” was declared by the International Swaps & Derivatives Association, the industry body that rules on pay-outs.
The payout was considered fair value by many strategists and investors. But these same strategists and investors said that this was more down to luck than design as the Greek debt exchange, under which private sector holdings of Greek debt were written down by about €100bn, failed to consider the potential negative fallout for CDS.
Michael Hampden-Turner, credit strategist at Citi, says: “I would like to see the market look very closely at how CDS works in the event of future sovereign restructurings. We had a lucky break with Greece in that the process went smoothly, but it might not do so the next time round.”
Portugal could be next major test
The next big test for credit default swaps may be Portugal, according to traders and investors, writes David Oakley.
Markets are already expecting a Portuguese debt default as bond prices are hovering around 50 per cent of par for benchmark 10-year debt, a distressed level.
Portugal has a smaller bond market than Greece, with about €100bn of government debt outstanding. A CDS net payout would also be a relatively small amount of $5.2bn, according to the latest figures from the Depository Trust & Clearing Corporation.
Yet, Portugal may be more important than Greece in shaping the sovereign credit default swaps market, say traders.
One head of rates at a leading bank says: “Portugal may prove to be the important one for the CDS market. If the country has to use private sector involvement [PSI] in its next bailout, and the CDS process runs smoothly, then that will be a big reassurance for markets over this instrument.”
A CDS trader says: “The Greek CDS process went smoothly. If Portugal saw a similarly smooth process, then that would increase views that this is a worthwhile product for the use of hedging.”
The Greek CDS auction, which settled the payout for the country’s default, went to plan as CDS and bond prices have signalled this outcome for a long time, say traders. This helped pave the way for an auction that delivered few surprises as the recovery rate, or payout, had been widely expected.
Investors delivered physical assets or bonds to settle their credit default swap payout in Monday’s action and then a final price was established for those investors that wanted cash in exchange for their contracts.
There were several broad categories of debt that were eligible for delivery.
These included Greek state-owned institutions that were not eligible in the private sector involvement process, such as Hellenic Railway bonds, a small number of short-term bills, international bonds under English law and new bonds, restructured under PSI.
The most important lesson, as far as bankers and investors are concerned, is that there should be a mechanism to settle CDS before bonds are exchanged in future restructurings. The private sector involvement initiative, or PSI, saw old Greek bonds exchanged for a range of new ones with varying maturities out to 30 years.
The end result in Monday’s Greek auction was not affected by the failure to have such a mechanism. This was because the new bond maturing in 2042, used to set the final pay-out as the cheapest security to deliver, traded at similar levels to old Greek bonds. The price that bonds finally settled at for the pay-out was also accurately forecast by the market, meaning no nasty surprises.
By setting a price of 21.5 per cent of par, the final pay-out on CDS was 78.5 per cent of the value of protection written. In other words, every buyer of $10m in CDS protection against a Greek default can expect a payout of $7.85m cash.
However, if there were another sovereign default, a quicker CDS settlement may be needed to ensure a similarly smooth process. Indeed, bankers and investors say the CDS trigger for a credit event, jargon that a payout should be made, came late and relied on technicalities, such as a certain percentage of bond-holders agreeing to exchange debt under “collective action clauses”.
One senior CDS trader at a US bank says: “In the finish, we all knew that Greece was heading for a credit event. It would have made sense to have that credit event happen earlier.”
Another delay such as that involving Greece, where bondholders had to use new debt in the auction, could lead to shorter-dated bonds with higher coupons being used as the deliverable securities, leading to a lower recovery rate. “This would make CDS settlement look much less fair, questioning it as an effective hedge,” says the trader.
In the case of Greece, the small size of the payout helped ease tensions. The biggest loser in the payout, according to European Banking Authority data up to last September, was likely to be UniCredit, the Italian bank, which may have to pay out an estimated €240m, small change for most big banks.
If a bigger country such as Italy or Spain defaulted on its debt, the story would be different, with larger sums involved and more at stake for buyers of CDS protection.
Mr Hampden-Turner says: “It is good to close the door, at least for now, on the sovereign debt story that has dominated headlines, allowing investors to move on. But, that said, there were a number of narrowly avoided pitfalls.”
For investors and bankers, sovereign CDS has passed its first test with Greece, the world’s biggest debt restructuring. But changes may be necessary for the product to pass further ones.

Sovereign CDS market needs to learn lessons from Greece, dealers say
Author: Mark Pengelly
Source: Risk magazine | 23 Mar 2012
Categories: Credit Derivatives

An auction to settle the Greek sovereign CDS goes smoothly, but some participants argue the documentation needs to be revisited
Documentation for sovereign credit default swaps (CDSs) needs to be reviewed to incorporate lessons from the Greek debt restructuring, dealers say. Despite this, some participants argue the triggering of a credit event and subsequent auction on March 19 shows the instrument is fundamentally robust.
The final recovery rate determined by the auction was largely in line with market expectations, at 21.5%. The auction followed months of uncertainty over whether the Greek CDS contract would be triggered – and whether protection buyers would receive a payout reflecting their loss if it were.
Nonetheless, dealers say the auction process went relatively smoothly. "The key point is this auction happened without surprise," says Francois Popon, global co-head of credit trading at Société Générale Corporate & Investment Banking (SG CIB) in London.
The auction was in line with market expectations, but we got lucky in getting there
As part of the restructuring plan, the Greek parliament voted to insert so-called collective action clauses (CACs) into the country's debt, which would allow Greece to impose a restructuring plan on recalcitrant bondholders. The CACs were triggered on March 9 – an act that was deemed to be a restructuring credit event by the International Swaps and Derivatives Association's European determinations committee.
Under the restructuring, bondholders received new 30-year Greek bonds with a face value of 31.5% of the face amount of the exchanged debt, plus a two-year debt obligation issued by the Luxembourg-based European Financial Stability Facility. Bondholders also received a detachable security with a payout linked to Greek GDP.
However, the exchange occurred before a credit event auction could be held, triggering fears that the outcome could be distorted. Specifically, market participants were concerned the value of new Greek debt would be higher than the old bonds, generating an auction result that would not reflect investor losses. In addition, Greece's international law bonds were not included in the initial debt exchange, leading to fears that the delivery of these bonds might also distort the auction outcome.
Ultimately, analysts say the recovery rate of 21.5% was close to the recovery rate on the original Greek domestic bonds. "In the end, the final price was extremely close to the initial mid-price that market-makers put on it, which means the auctions were in line with expectations. There were quite a lot of bids in the order book, so it was a well-arbitraged auction. Given there was no surprise at the auction, there is no surprise in terms of profit-and-loss impact," says Popon.
The result was a lucky break for the sovereign CDS market, argues Michael Hampden-Turner, European head of collateralised debt obligation research at Citi in London. "The auction was in line with market expectations, but we got lucky in getting there. It was reasonably fortunate that it all came together. It's highlighted the fact that we might need to make some changes to the way sovereign CDSs handle restructurings going forward," he says.
Some market participants remain frustrated the CDS contracts didn't trigger sooner, as it became obvious the country was heading for a credit event. This could have allowed them to deliver old Greek bonds into the auction, effectively safeguarding it from the possibility of a strange outcome.
According to Hampden-Turner, one way to improve the contract could be to make any alteration to the terms of domestic debt constitute a restructuring credit event. "One possibility for change is to insert a rule into CDS documentation that states if a government puts legislation to its parliament that changes the rules of domestic bonds retroactively, this should be a trigger point. In the case of Greece, this would mean the insertion of the CAC, rather than the use of the CAC," he says.
Another option might be to broaden the scope of deliverable obligations in the CDS auction to include any other securities that investors receive as part of a restructuring, such as the two instruments received by investors in the Greek debt swap.
David Geen, London-based general counsel at Isda, is sceptical about the insertion of CACs triggering a restructuring credit event. However, he agrees there are lessons to be learned from the auction. "The auction worked well because the value of the new debt ended up looking like the old debt, so people got what they would have expected if the old debt had traded at auction. But we need to look at the process over time to see what we could do to improve it. Greece was an important auction and I'm sure we can learn from it," he says.
Other market participants are less eager to revisit the terms of sovereign CDS. In the corporate CDS market, restructuring credit events have frequently been difficult to navigate, often prompting complaints from market players. One London-based senior credit derivatives trader says the risks involved in the Greek auction should not have come as a surprise to market participants. "This kind of situation happens all the time in the corporate CDS market. It is part of the normal functioning of CDSs. I'm comfortable with that, and I think the market showed its robustness quite well," he says.

Sovereign CDS: lessons from the Greek debt crisis

Richards Kibbe & Orbe LLP
Jennifer Grady and Richard J. Lee
Greece
March 16 2012

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Greece is proceeding with the largest sovereign debt restructuring in history after its bondholders accepted a significant debt reduction in the face of mounting evidence that a Greek default was inevitable without such relief. In a related market development garnering only slightly less attention than the debt restructuring itself, the International Swaps and Derivatives Association, Inc. (“ISDA”) announced on March 9, 2012 that a “credit event” had triggered Greek credit default swaps (“CDS”) as a result of Greece’s imposition of the terms of the restructuring on non-consenting holders of bonds governed by Greek law.

Multiple events during the course of the extraordinary restructuring led to the determination that a credit event had occurred, and sovereign CDS market participants followed the developments closely. Although Greek CDS contracts will be settled in the weeks ahead, heightened attention on the debt burden of other European sovereign issuers, including Portugal, Spain and Italy, suggests that the saga of sovereign CDS in Europe may not end with Greece.

In this memorandum, we outline the general structure of Western European sovereign CDS and summarize the fundamental features of these transactions highlighted by the Greek experience.

BACKGROUND: WESTERN EUROPEAN SOVEREIGN CDS

Sovereign CDS enables market participants to purchase protection against the risk of default of a state, government or certain governmental authorities. ISDA has published standard sets of terms that apply to various categories of sovereign CDS contracts, and “Western European” describes the category that includes Greek sovereign CDS (referencing the Hellenic Republic as the “Reference Entity”), as well as CDS referencing other high-profile sovereign entities, including Portugal, Spain and Italy.

At the most basic level, CDS is a financial contract pursuant to which the buyer purchases protection from the seller against the risk of the occurrence of certain predefined defaults, or “credit events,” with respect to a specified reference entity. During the term of the CDS contract, the buyer makes periodic payments to the seller in exchange for the seller’s promise of protection, and if a credit event occurs, the parties settle the contract to enable the buyer to collect its protection payment. Typically, the parties “cash settle” pursuant to an auction process, where the seller makes a cash payment to the buyer based on an auction-generated market price of certain eligible debt obligations of the reference entity. In the absence of an auction, the buyer receives the benefit of its protection through “physical settlement,” pursuant to which it delivers an eligible debt obligation of the reference entity in exchange for a cash payment equal to the par value of that obligation. The decision as to whether a credit event has occurred is typically made by a “Determinations Committee” (“DC”), which is comprised of ten voting dealers and five voting nondealer market participants, based on an analysis of the relevant contractual language contained in the 2003 ISDA Credit Derivatives Definitions (the “Definitions”).

Three credit events can trigger a buyer’s protection under a Western European sovereign CDS transaction: Failure to Pay, Restructuring and Repudiation/ Moratorium.

A “Failure to Pay” credit event is the most straightforward and applies to all other types of standard CDS transactions, both sovereign and corporate. This credit event will be triggered by a payment default in an amount of at least USD 1 million by the reference entity on certain defined debt obligations (“Obligations”) after the expiration of any grace period.
A “Restructuring” credit event can be triggered by the occurrence of one of five specified events with respect to the reference entity’s Obligations in relation to an amount of USD 10 million or more. These five events include: (i) a reduction in interest payable, (ii) a reduction in principal or premium payable, (iii) a postponement or deferral of certain payment or accrual dates, (iv) a change in ranking or priority resulting in “Subordination,” as defined in the Definitions, and (v) a change in the currency of a payment to any currency that does not qualify as a “Permitted Currency.” Various conditions must be met before a Restructuring credit event can occur, including that the relevant event must occur in a form that binds all holders of the relevant obligations, and that the event must result from a deterioration in the creditworthiness or financial condition of the reference entity.
A “Repudiation/Moratorium” credit event applies only to sovereign CDS, not corporate CDS. In order for this credit event to be triggered, two conditions must be satisfied: (i) the sovereign entity must either repudiate or declare a moratorium on payments under its Obligations in relation to an amount of USD 10 million or more and (ii) within a specified period of time (generally, 60 days after the initial repudiation or moratorium declaration), a “Failure to Pay” or “Restructuring” must occur, without regard to the amount of the affected debt.
While these general descriptions of the relevant credit events provide a basic overview of Western European sovereign CDS contracts, understanding the terms of any CDS contract requires a close and careful review of the relevant contractual language contained in the Definitions, particularly with respect to credit events. While some market participants have recently bemoaned the ineffectiveness of CDS contracts in protecting against certain losses, a review of the contractual language makes many of the risks underlying these transactions knowable.

UNDERSTANDING THE RESTRUCTURING CREDIT EVENT AFTER GREECE

The intense focus on Greek CDS in the context of the Greek debt restructuring has highlighted the importance of understanding the nuances of the “Restructuring” credit event as applied to Western European sovereign CDS contracts.

Voluntary Restructurings are Unlikely to Trigger

As described above, a “Restructuring” credit event must occur in a form that “binds all holders” of the relevant obligation. Because of this contractual condition, unless all of the relevant holders consent to a restructuring, it is highly unlikely that an entirely voluntary debt restructuring would trigger a credit event.

Impact of Collective Action Clauses

A collective action clause, or CAC, is a set of provisions in bond documentation that enables a specified supermajority of bondholders to bind minority holders to certain restructurings and other modifications to the terms of the bonds. CACs can facilitate an orderly restructuring by enabling the sovereign issuer to avoid costly and lengthy negotiations with hold-out creditors who may have differing objectives. CACs are frequently found in sovereign bond documentation, particularly where governed by English law and, increasingly in recent years, New York law. However, Greek bond documents governed by Greek law did not include CACs at the time those bonds were issued.

On February 23, 2012, Greece retroactively imposed a CAC on its Greek law governed bonds by enacting Law No. 4050/2012, known as the Greek Bondholder Act, which would allow Greece to force all holders of those bonds to participate in the proposed debt exchange so long as it received the approval of holders of at least two -thirds (2/3) by face amount of a quorum (constituting one-half (1/2) by face amount) of such bonds. By modifying the terms of these bonds through legislation, Greece heightened investors’ fears that sovereign issuers have wide latitude to change their laws in order to impair the rights of the holders of bonds governed by domestic law.

Greece’s enactment of the Greek Bondholder Act not only has widespread implications for sovereign debt restructurings in general, but also serves to highlight the impact of CACs on sovereign CDS transactions.

First, as the DC unanimously determined on March 1, 2012, the mere passage of the Greek Bondholder Act by the Greek legislature did not constitute a credit event. Although this outcome surprised some market participants, this result is not controversial under the CDS definition of “Restructuring.” While the inclusion of a CAC, or the passage of a law such as the Greek Bondholder Act, may indicate that a debt restructuring proposal could be forced on minority holders, a CDS credit event is unlikely to occur until the necessary supermajority of bondholders has actually agreed to enable the sovereign issuer to use the CAC to effect a restructuring. In this case, it appears that on March 1, the DC was asked to call a credit event prematurely.

Second, the use of a CAC will, in most cases, make the occurrence of a Restructuring credit event more likely. Assuming all other conditions to the occurrence of a Restructuring credit event are satisfied, the use of a CAC may be one of a limited number of ways that a sovereign issuer can achieve a restructuring that “binds all holders” of its debt obligations.

The Economic Pain of Effective Subordination is Insufficient to Trigger

Events in Greece have also illustrated the importance of a close review of the definition of “Subordination” in CDS contracts. Under the Definitions, a Restructuring credit event can be triggered by a change in the ranking or priority of an Obligation which causes the “Subordination” of that Obligation to another. “Subordination” must involve a “contractual, trust or similar arrangement” providing that either the claims of holders of the senior obligation will be satisfied prior to those of the subordinated obligation in the case of a liquidation, or that the holders of the subordinated obligation will not be entitled to receive any payments if the reference entity is in default on the senior obligations.1

On February 24, 2012, a CDS market participant asked the DC to determine whether a Restructuring credit event under Greek CDS was triggered when Greece allowed the European Central Bank (the “ECB”) to exchange its Greek debt obligations for new bonds prior to the enactment of the Greek Bondholder Act and excluded such new bonds from the obligations affected by the CAC, thus shielding the ECB from being forced to accept the debt restructuring. Despite arguments that this pre-CAC exchange effectively subordinated other bondholders to the ECB by granting the ECB with more favorable terms, the DC unanimously decided that the ECB exchange did not constitute a credit event.2 The contractual language contained in the Definitions does not allow for the argument that “effective” subordination that may exist between the ECB and other holders of Greek bonds should trigger CDS. The fact that one creditor or group of creditors is treated more favorably than another, without further evidence of contractual or otherwise legally mandatory payment subordination, will generally not be sufficient to satisfy the contractually defined threshold for “Subordination” in CDS.

CONCLUSION

The Greek experience has subjected the CDS market to heightened scrutiny over the past few months, and the events leading up to the trigger of Greek CDS have provided market participants with greater insight into the nuanced technical, economic and political factors that will determine whether and when Western European sovereign CDS will provide protection payments to buyers of protection. As market participants attempt to gauge the impact of other potential sovereign defaults in the eurozone, the lessons of the Greek bond restructuring should remind sovereign CDS market participants to review the relevant “credit event” definitions carefully and take a broad view of a sovereign’s ability to modify existing contractual terms in a time of crisis. Both lessons are essential to a comprehensive understanding of the risks and benefits inherent in sovereign CDS transactions.

Will Greek CDS ever trade again?
By Felix Salmon APRIL 2, 2012 Email Print inShare GREECE | SOVEREIGN DEBT
Back on March 23, Christopher Whittall explained why we don’t have a good go-to measure of Greece’s creditworthiness, in the wake of its big bond exchange: Greece’s credit default swaps can’t trade yet. There’s something called a 60-day look-back clause in the standard CDS documentation, which means that if a country has defaulted in the past 60 days, somebody who owns credit protection can claim that there has been an event of default and ask to be paid out. Since we’re still well within 60 days of the default event on March 9, anybody buying Greek credit default swaps now could trigger them immediately.

But after today’s news, it’s far from clear that Greek CDS will even start trading after the 60 days are up. It turns out that while Greece managed to swap its old domestic debt into new bonds quite seamlessly and easily, the same’s not true of Greece’s foreign bonds.

In a statement, the Public Debt Management Agency said investors holding 20 of the 36 bonds in question either voted down or otherwise failed to approve key changes to the bond contracts…

Last week euro-zone finance ministers issued a statement which hinted strongly that they would back Greece if it didn’t make the payments on foreign law bonds.

On May 15, Greece must redeem one of those foreign law notes worth €450 million.

Basically, there are now roughly €9 billion of bonds outstanding which are still old bonds which haven’t been swapped. And those bonds are likely to be a real headache for Greece. The obvious thing for Greece to do would be to simply refuse to pay anybody who holds those bonds and didn’t tender into the exchange. I would certainly follow that course, if I were in Greece’s shoes.

But that would mean that there would be a second Greek default — and that going forwards, there would be a semi-permanent stock of defaulted Greek debt out there. In turn, that would make it difficult to trade Greek CDS, since Greece is likely to be in default, on billions of dollars of foreign debt, for as far as the eye can see.

Now it’s possible to ring-fence that debt and say that it doesn’t count towards a CDS trigger. Non-trivial, but possible. The question is whether anybody really has the appetite to do that. Or whether Greece, and the Eurocrats paying its bills, would actually be quite happy if Greek CDS didn’t trade at all from here on in.

This thesis has investigated the determinants of sovereign CDS spreads before and after the financial crisis for 11 European countries. The period of analysis is January 2006 to April 2011, which has been divided into 3 sub–periods.
The first period is the time up until the default of Lehman Brothers in September 2008.
The second period lasts until late 2009 and is marked by the implementation of bank rescue packages and a subsequent financial stabilization.
The third period is characterized by the European debt–crisis.
Since June 2007 the sovereign CDS market has attracted considerable attention and the credit markets have been subject to an unprecedented repricing of credit risk. The collapse of Lehman Brothers resulted in large losses for many financial entities which caused damaged investor confidence and a decline in the availability of credit. Massive support for the banks and other stimuli increased the public sector deficits and took the sovereign debt to record high levels. This meant that the risk of default of developed sovereigns became real – especially for a number of European countries. The first part of the analysis examines the risk transfers between the banks and the sovereigns. The results indicate that a risk transfer from the banks to the sovereigns took place in October 2008 with the introduction of financial rescue packages. However, the development of the sovereign debt levels and the pressure on the European economy induced that some of this risk was transferred back to the banks from November
2009.
The next step in the analysis shows a strong co–movement across the countries in both CDS and bond spreads. The nature of this co–movement is examined by OLS regression and is for CDS spreads found to be very similar to the iTraxx Europe index. For bond spreads none of the chosen market factors were able to explain theco–movement.
For the actual analysis of the determinants a number of theoretical determinants are identified based on the Black–Scholes–Merton structural framework and previous research.
This results in three groups of variables; global, local and risk. The overall findings indicate that in period 1 global factors are dominating, both for CDS and bond spreads. In period 2 and 3 the local variables gain more explanatory power. Moreover in period 3 the risk factors become significant. Hence, a repricing of sovereign risk has taken place.
Finally an examination of the price discovery in the CDS and bond market, using Granger’s causality test, shows that the CDSs have gained more significance in the pricing process through the three periods.

2.1.1 The use of CDSs
Sovereign CDS contracts are like most CDS contracts used as trading instruments rather than pure insurance. At the most basic level CDSs are, from a buyer’s point of view used to buy default insurance and from the seller’s used as an additional source of income. The CDSs are however in practice used by the market participants for several other purposes than this.
2.1. Credit default swaps
Many banks have large holdings of government bonds and with the development seen in the European countries, banks can use sovereign CDS to hedge their country risk. This development will be further discussed in section 3.2. Banks also use CDSs to export risk from their balance sheets which results in a lower required capital reserve due to regulation. The
CDS market enables banks to go short in credit and in this way transform buckets of risk using derivatives and thus undermine the fundamental idea of capital weights implemented with the Basel requirements. This is favourable since the banks transform risk without trading as much in the underlying (Blundell-Wignall and Atkinson, 2010). Furthermore, some market participants also enter CDS contracts even if they do not have any exposure to the underlying, also called a naked position. This makes buying the CDS similar to shorting the underlying bond since the market value of the position in the CDS would increase as the credit quality of the reference entity deteriorates. During the financial crisis banks and hedge funds have been accused of exacerbating the crisis using naked positions (Delatte, Gex and Villavicencio, 2010).
Sellers of CDSs use the market to enhance yields on their portfolios and to diversify their credit risk exposure – i.e. tailoring their credit risk profile. One thing that is especially motivating for protection sellers is the fact that entering a CDS contract does not require any upfront funding and the seller can thereby obtain exposure to large amounts of debt with essentially no upfront cost - except for the possible cost of posting collateral (to minimize counterparty risk, seen from the buyers perspective). This can be especially attractive to investors with high funding cost. This is opposed to getting the same exposure by buying the bonds issued by the reference entity which would require a significant initial cash outlay. Furthermore CDSs are attractive since they enable investors to obtain exposure to entities which would otherwise be difficult to establish, e.g. a company whose debt is closely held by a small number of investors. Instead an investor can sell a CDS contract and in this way receive a cash flow which is closely linked to the cash flow that investors would have received from buying the reference entity’s debt directly, also called a synthetic position (Bomfim, 2005). CDSs can also be used for arbitrage trading, e.g. government bonds vs. CDSs, also called basis arbitrage. The basis is defined as the difference between the CDS spread and the spread on the underlying government bond. The basis provides insight to how well sovereign credit markets function because the CDSs and underlying bonds tend to trade similarly due to the market’s view on default risk (Beinstein and Scott, 2006; Fontana and Scheicher, 2010). Hence, both sovereign bonds and CDSs offer exposure to sovereign debt.
The increasing risk of a restructuring of the Greek debt is reflected in at the same time increasing CDS spreads and increasing interest rates on government bonds.

Economic and political stability is tied closely to credit risk. If financial markets expect changes in the credit risk this should be reflected in the sovereign CDS spread of the country, as CDS spreads are a measure of the creditworthiness of the underlying issuer. In recent years there has been a significant change in the pricing of credit risk which can be seen in figure 3.1. The figure shows that the Greek CDS spread has increased significantly since the start of the period. The standard deviation of the Greek 5–year spread for the whole period is 315 bps and has a maximum of 1074 bps, which is the highest among European countries. The numbers for 10–year CDS spreads are very similar, although slightly lower.

Inspired by IMF (2010a) the repricing process can be divided into 4 phases. First the
‘Financial crisis build up’ which started with the collapse of Bear Stearns Hedge Fund in
June 2007. This initiated an increase in risk aversion and a flight to quality, i.e. investors rebalanced their portfolios towards less risky securities (Beber et al., 2009). This supported core sovereigns such as Germany and France, while this made interest rate spreads widen for other countries. Both Germany and France are perceived as less risky sovereigns, which is reflected in the low level of the CDS spreads (figure 3.1 and appendix A.4). The second phase was a period of ’Systemic outbreak’ and started in September 2008, when Lehman
Brothers defaulted. In this period many financial institutions incurred write downs related to subprime mortgages, decline in availability of credit and damaged investor confidence.
This had serious impact on the financial sector of several European countries, e.g. Ireland.
A number of countries stepped in to help their distressed financial sectors with immense rescue packages. In March 2009 AIG announced new losses of $61.7bn. for the last 3 months of 2008. This triggered a second bailout from the US government of $30bn. (BBC,
2009). (More on the development in the European financial sector in section 3.2). This made CDS spreads narrow again as the fear of a systemic crisis declined and global risk aversion decreased and hence the third phase, ’Stabilization’, began in April 2009. Rescue packages for several countries had in this period become effective which made the fear of a systemic breakdown decrease and the markets calmed. However, from November 2009 the spreads again started to widen in connection with the European debt crisis becoming more evident. In this phase four, sovereign default risk has become a significant factor and the spreads for economies with weaker fiscal outlooks and financial strains have increased significantly – this is especially evident for Greece. The immense size of the rescue packages to the financial sectors has contributed to increased fiscal concerns and had a liquefying effect on the sovereign CDS market for developed countries. Before the crisis trading in credit markets was mainly concentrated on private sector instruments such as CDSs on corporate debt.
As can be seen from figure 3.2 the notional amount of sovereign CDS outstanding has been increasing continuously since 2nd half year 2008 which is where the systemic outbreak phase started. This has resulted in a 45% increase from the 2nd half year of 2008 to the 1st half year of 2010. Sovereign CDS’ share of the total CDS market measured in the notional amount outstanding has from the beginning of 2006 to mid 2010 increased from 3% to 8%, which gives evidence to the increased focus on sovereign risk. All these above-mentioned events have increased focus on the sovereign debt markets. The large public sector deficits that are now seen in several European countries have caused a reassessment of the default risk of developed countries.
3.1.1 Fiscal Policy
One big question is how did the debts of several of the EU countries rose to the levels we see today. The problems particularly seen in Greece have raised the awareness of the problems of the divergent fiscal policies in the Euro area. The reasons for the rising budget deficits (and public debt) in almost all of the countries are loss of tax income and increased public expenses in the wake of the financial crisis together with extensive fiscal stimuli. Table 3.1 shows the public budget deficits as a percentage of GDP. In 2009 the GIISP countries,
France and the UK are above the allowed 3% level from the Treaty of Maastricht. When countries exceed the allowed amount they are asked to cut down the deficit in the near future (typically 3-4 years) and this has resulted in convergence- and stability programmes for most of the EU-countries. All EU-countries except Sweden, Luxembourg and Estonia have been incorporated in the EU’s deficit procedure (Danmarks Nationalbank, 2010b).
The public deficit of Greece has risen significantly from 2006 to 2009, from 5.7% of GDP to 15.4%. The same scenario is evident for Ireland who turned a surplus of 2.9% of GDP in 2006 to a deficit of 14.4% of GDP in 2009. Looking at Germany its deficit has in the same period only increased from 1.6% of GDP to 3% up until 2009. The forecasts for
2010, 2011 and 2012 show that all the countries are expected to decrease their deficits during the period, but only Germany, Sweden and Finland may be able to comply with the 3%-requirement in the near future. According to Danmarks Nationalbank (2010a) the need for fiscal consolidation is largest in Greece with almost 25% of GDP, but also
Ireland, UK and Portugal rank high on the list with consolidation needs of approximately
22%, 19% and 16% respectively. For the Euro-area as a whole the need is 12% of GDP.
There are different opinions on whether or not fiscal austerity has a subduing effect on the economic growth or not, but either way, the debt problems in several of the countries are so severe that there is no other choice than to begin an extensive tightening of the fiscal policy (Danmarks Nationalbank, 2010a).
This historic deterioration of the public finances has lead to a fear of a government debt crisis in several industrial countries. In Greece the situation has worsened since fall 2009 and the country has experienced increasing interest rates, tightened budgets and rescue package from the Euro-countries and the IMF. The situation in Greece has intensified the fear of sovereign default and has had a contagious effect on the other GIISP-countries.
These concerns of contagion have had an increasing effect on risk premia and the CDS spreads and increased the financing cost for the countries. Fiscal sustainability has come into focus also for countries that have traditionally been perceived as very creditworthy and this has led to a renewed focus on the default risk of high government debt.
3.1.2 Debt and Interest Rates
In the years before the euro was introduced there was a significant convergence in the interest rates on the European sovereign bonds. The low interest rates and reduced macroeconomic and financial insecurity caused risk premiums on government bonds to decrease significantly. Differences in interest rates between countries still existed though due to differences in e.g. size, liquidity and creditworthiness. From figure 3.3 it is seen that in phase 1 the European government bond rates were very similar. The spread to the euro swap rate was on average -0.42% and -0.18% for 2 and 10-year bonds respectively. UK was in this period the country with the highest spread, 0.09% (2–year). In phase 2 the spreads widened for several of the countries. This is especially evident for Greece and Ireland with
2–year spreads of 0.50% and 0.53%. The assessment of the systemic risk in the financial sector had a significant impact on the government bond interest rate. Countries like Ireland and some of the Nordic countries all had large financial sectors and therefore early on adopted comprehensive state guarantees. This development can be seen in the Danish 2-year spread which increased from -0.34% in phase 1 to -0.05% in phase 2 (the 10-year spread increased from -0.26 % to -0.14%). The average spread for phase 2 increased to
-0.36% for 2 years and 0.20% for 10 years.
In phase 3 the spreads for all countries, except for Greece and Italy, kept increasing. The government bond rates for all countries had all decreased, but both the 2–year and the
10–year swap rate decreased more which made the spreads increase. The acute financial unrest had passed and the investors’ concerns were mainly pointed towards southern Europe while the Nordic Countries were seen as a ’safe-haven’. The average spreads increased to -0.23% (2 year) and 0.42% (10 year). Greece and Ireland still had the greatest spreads,
Greece due to its sovereign debt level and Ireland mainly due to the state of its financial sector. Phase 4 has been marked by increasing concern of the fiscal sustainability in many sovereigns and this has contributed to significant increases in the spread for Greece (which reached a record high 6.51% for 2-year bonds), Ireland, Portugal and Spain. This made the average spreads for period 4 increase to 0.75% (2–year) and 1.20% (10–year).
After a number of years of growth, several of the European countries still had not consolidated their public finances. This meant that in 2006 the debt/GDP level for the eurocountries was unchanged since 2002 at 68%. For all of the 27 EU countries the debt level was 61.5% of GDP in 2006, an increase of 1.1%-point compared to 2002. From figure 3.4 it is clear that especially Greece and Italy have had high amounts of debt for a longer period.
From 2007 to 2009 Ireland’s debt increased from 25% of GDP to 65.5% and is expected to reach 96.2% of GDP in 2011. This massive increase in such a short time span has been caused by a sharp increase in unemployment, excessive exposure to the construction sector which caused great valuation losses when the Irish property bubble burst, large capital injections to distressed banks and the nationalization of the Anglo Irish Bank (European
Commission, 2010). At the same time a significant decrease in Ireland’s GDP of almost
16% from 2007 to 2009 has contributed positively to the rise in the debt/GDP-ratio. Also
UK’s debt has increased significantly from 44.5% in 2007 to 68.2% in 2009, which is partly due to the size of the bank rescue packages. The forecast for UK for 2011 shows a debt level of 88.2%. Even though several countries have had debt above the 60%-level, which is one of the convergence criteria from the Treaty of Maastricht, nobody worried about debt–levels due to the low interest rates and a positive economic outlook.
As earlier mentioned, the financial crisis led to a flight-to-safety. This flight can be divided into two scenarios; flight-to-liquidity and flight-to-quality. According to Beber et al. (2009), in times of financial distress it is often observed that investors rebalance their portfolios towards less risky and more liquid securities, especially in fixed income markets. This is called flight-to-quality and flight-to-liquidity respectively. Beber et al. (2009) found that credit quality matters for bond valuation, but that in times of market disstress investors chase liquidity, not credit quality. When the demand for ’safe-haven assets’ goes up the prices also increase which cause the yields to decline. Since countries like Germany and
France were considered as safe the yields on their government bonds decreased, even below the swap rate, see figure 3.5. Both countries have the highest ratings, confirming the flight-to-quality scenario, but at the same time also have some of the largest amounts of bonds outstanding among the European countries (Suoninen and Chopra, 2011). An investment in these two countries can therefore prove to be a flight to both quality and liquidity. This investor strategy has so far also been supported by the Basel II requirements where the standardized approach gives a risk weight of zero to government debt with a rating above
A+.
The introduction of the governments’ rescue packages for the banks was overall perceived by the market participants as a risk transfer from the financial sector to the governments
(Ejsing and Lemke, 2010), which will be further discussed in section 3.2 and 3.3. This risk transfer made the focus shift to the quality of the state finances of the countries and has since 2009 increased the risk premiums of especially the GIISP countries. From spring
2009 the countries’ central banks introduced extensive monetary policy measures. This was necessary since it was no longer possible to lower the rate which was already close to zero. At the same time ECB provided cheap loans for the banks and unlimited borrowing for 12 months at a 1% fixed interest rate (Danmarks Nationalbank, 2010b). This stabilized the government bond market and resulted in significant decline in the short interest rate spreads. These measures made investment in government bonds financed by loans cheap and thereby increased the banks’ holding of government bonds. The access to unlimited liquidity and renewed risk appetite caused the interest rate spreads to decline in the following period. In the fall of 2009 new unrest arose in the markets. This was mainly caused by the new Greek government who revised the deficit forecast from 6–8% to 15.4% (Petrakis and
Ziotis, 2010) which again led to an increase in the interest rate spread and downgrading of the country’s credit rating. In October 2009, Fitch downgraded Greece from A to A- and with a continuing negative outlook (Fitch, 2011). The assessment of fiscal sustainability in
Greece, and several other countries, changed quickly due to the fast growing deficits and a downward revision of future growth. This resulted in expectations of higher debt levels and increasing interest rates. Investors realized that the risk of Greek bankruptcy was real and nothing could prevent the Greek interest rates from rising. As the Greek interest rates spread rose in the beginning of 2010 signs of contagion to other EU countries were showing. Since the Greek economy only amounts to around 2.5% of the euro-area GDP in 2010 meaning the spillover was not due to a real economics mechanisms. Instead it reflected the insecurity of how the EU would handle a situation where Greece was no longer able to issue government bonds. If the EU did not help, it would decrease the probability of other countries in distress receiving help from the EU. In the case of default of the
Greek economy, two large risks would exist. First, was the fear that a non-fulfillment of
Greek obligations would cut off several other countries from the international capital markets.
Secondly, was the risk that several of the European banks had significant amounts of
GIISP country government bonds in their portfolios. This will be elaborated in section 3.2.
The fear of new large losses grew - only 1.5 years after the collapse of Lehman Brothers
- which could again destabilize the financial system (Danmarks Nationalbank, 2010b).
In Marsh (2010) the complicated web of debt in Europe is shown. The web of debt shows that the five GIISP countries have large amounts of debt not only to each other but also to
Britain, France and Germany. Of Italy’s debt of 1.4 trillion dollars the debt to Germany makes up $190bn., $511bn. to France and $77bn. to Britain. For France this amounts to almost 20% of the country’s GDP in 2009. Italy is one of the countries with the highest debt, however the example gives an indication of the complicated web of debt and it will therefore have devastating consequences which makes the help from the EU and IMF very important. In April 2010 Greece applied to the euro-countries and IMF to receive economic help. This was however not enough to calm the markets and the unrest spread outside
Europe and led to significant declines in global stock markets. The interest rate spreads still continued to increase and other countries with disturbing debt development such as
Spain and Portugal were brought into focus. At the same time the investors still considered restructuring of the Greek economy as a significant risk (Danmarks Nationalbank, 2010a).
This increasing market unrest led to a rescue plan of 110 billion euros from the EU and
IMF in May 2010, where the parties agreed on comprehensive financial guarantees. At the same time ECB announced more monetary and political measures including purchasing of government bonds with high interest rate spreads in the secondary market. Together with the stress test of the European banks in July 2010 made the markets calm down for a short while.
Already in August 2010 did the interest rate spreads widen again. This has especially been the case for the GIISP-countries, which is clearly pictured in figure 3.5. This was mainly caused by an announcement from the Irish Ministry of Finance on the 30th of
September which stated that the budget deficit would be around 32% of GDP due to expenses for the distressed Irish banks. The Irish banks were cut off from borrowing in the market and were dependent on liquidity from the ECB. In November 2010 Ireland made a loan agreement of 85 bn. euros from the EU and the IMF. Of the 85 bn. the Irish state contributed with 17.5 bn. euros from pension reserves and cash (Danmarks Nationalbank,
2010b). Conclusively, the existence of the EFSF in itself was not enough to calm the investors since the rescue of the Irish economy has not had a significantly stabilizing effect on the government bond markets.
On March 21st 2011 the EU again agreed on a new fund called the European Stability
Mechanism (ESM) which will come into effect in 2013 when the current fund (EFSF) expires. ESM will have a lending mechanism of 500 bn. euros and loans from here will have lower interest rates than loans from the EFSF. ’Market forces cannot have even the slightest doubt about our capacity to act even in the most stressed scenarios’, said Olli Rehn
(the European commissioner for economic and monetary affairs) after the agreement (New
York Times, 2011). However, the interest rates on government bonds have continued to increase after the announcement of the ESM.
As mentioned earlier more EU-countries have experienced disturbing developments and
Portugal was the next country to ask the EU and IMF for help. In March 2011 the
Portuguese prime minister resigned from his position after failing to achieve new budget savings approved. This increased the uncertainty of the country’s future finances and resulted in further downgrading from the rating agencies, e.g. Fitch downgraded Portugal from A- to BBB- on 01.04.2011 and still has a negative outlook for the country. Thereby
Portugal now has the lowest possible rating in the investment grade category. If Portugal gets further downgraded it will probably result in massive sell offs of Portuguese government bonds since many institutions are not allowed to invest in non-investment grade bonds and this will cause interest rates to rise further. Already the Portuguese interest rates have risen significantly in the last year (06.04.10-06.04.11) from 1.60% to 8.84% for
2-year bonds and 2.96% to 9.75% for 5-year bonds (Nordea Analytics). This has increased
Portugal’s interest rate costs significantly and on the 06.04.2011 Portugal asked the EU for help, same day as the country had successfully issued government bonds for 1bn. euros
- though at high rates of 5.11% and 5.9% for 6 and 12 months respectively (Børsen, 2011).
The fact that the interest rate spread to Germany was above 5%, was a significantly contributing factor to Portugal finally asking for help. Receiving loans from the EU and IMF can reduce borrowing cost significantly, e.g. Ireland is paying an average of 5.8% (Doyle and Brennan, 2010) on their debt while Portugal at the moment is paying close to 10%.
In the long run it would not be possible for Portugal to achieve financing in the market.
28 For now default of Portugal is averted, but in the long run the loans from the EU and the IMF will not be enough to avoid default. Consequently, Portugal is forced to make internal reforms. Like Greece, Portugal’s GDP does not make up a large part of the EU’s total GDP, only 1.4%, but as earlier mentioned many of the ’healthier’ EU-countries hold large amounts of government bonds from the distressed countries. Of Portugal’s $286bn. debt, Spain holds $86bn., Germany $47bn. and France $45bn. After Portugal has decided to ask for help it is expected that focus will shift to Spain whose banking sector could be in bigger trouble than expected due to the burst of the real estate bubble (Børsen, 2011).
Default of Spain will cause bigger problems since Spain measured on GDP is almost twice as large as Ireland, Portugal and Greece together (2010, Eurostat).

a. Counterparty Risk. In principle, the higher the counterparty risk of the seller of protection via CDS is, the lower should be the CDS spread charged as a result of the lower quality of the protection.
We test for this effect by using the first principal component obtained from the CDS spreads of the main 14 banks which act as dealers in that market.9 The first principal component series should reflect the common default probability and, hence, it is akin to an aggregate measure of counterparty risk.10 Actually, the first PC for the series of CDS spreads of this set of dealers explains 87.5% of the total variance of the observed variables. b. Liquidity. In theory, one would expect that higher liquidity in the bond market relative to the CDS market would go hand in hand with a higher basis, since a more liquid bond implies a higher price and, hence, a lower bond spread.
To test for this relative liquidity effects, we construct a ratio of relative liquidity between the bond and the CDS. Specifically, the degree of liquidity in the CDS market is proxied by the relative bid-ask spread which is obtained as the ratio between the bid-ask spread of the CDS premium and the mid-premium, i.e. (Ask-Bid)/((Ask+Bid)/2). The higher this ratio is, the lower is the degree of liquidity in the CDS market. A similar measure of liquidity is computed for the bond market and the ratio between both is taken as indicative of the relative liquidity in the bond market vis-à-vis the CDS market. As this ratio rises, liquidity in the bond market relative to the CDS market falls and so does the basis.
c. Financing Costs: One would expect that higher financing costs would lower the demand for bonds, as buying them require funding, and could lead to a decrease in prices, and hence, to higher bond spreads. The effect of funding costs on CDS spreads should be lower given that in this case the required amount of funding to get the same (gross) risk position is lower (i.e. risk-leverage is higher in the case of the CDS investment). For this reason, an increase in financing costs would have a negative effect on the basis. Due to the difficulty in obtaining data on institution-level funding constraints, we use the spread between financial commercial paper and T-bill rates as a common proxy for the funding constraints faced by financial intermediaries, as in Acharya, Schaefer and Zhang (2006). Specifically, we use the spread between the 90- day US AA-rated commercial paper interest rates for the financial companies and the 90-day US T-bill.
d. Domestic and global risk premiums: As additional potential explanatory variables for the basis, we consider a measure of the country and global risk premium. If both the CDS and bond spreads are prices for the same credit risk, the effect of the country specific and global risk premiums on the basis should be non-significantly different from zero. However, in order to control for the fact that this idiosyncratic and global volatility could be priced differently in the two markets, we use the previous risk factors as additional explanatory variables. The country-specific risk premium is proxied by means of the stock market volatility. The global risk premium or global risk is proxied by means of the VIX Index. The correlation between the VIX Index and the counterparty risk variable is around 0.8. Thus, in order to avoid any multicollinearity problem, we modify the counterparty-risk variable and define it as the residual of the regression of the first principal component CDS spreads corresponding to the main CDS dealers onto the VIX Index such that counterparty risk and VIX are now orthogonal variables and the counterparty risk is not related to changes in the perception of global risk.
e. Bond-CDS Spillovers: We here use the notion of spillovers between the CDS and the bond markets as the variation in the CDS (bond) spread that is notattributable to its past values but to contemporary shocks to the bond (CDS) spread. To measure such spillovers or contagion-effects, we use a procedure based on Diebold and Yilmaz’s (2010) methodology and described in Appendix A.1. The Bond-CDS spillovers variable is obtained after dividing the spillovers from the changes in bond spread to the changes in CDS spread relative to spillovers from the CDS to the bond spread changes. This variable reflects the increase in a given spread due to a direct effect of the other market.
We work in relative terms because the dependent variable is the difference between both credit spreads. A positive (negative) sign implies that when the ratio increases, that is, the shock transmission from the bond market to the CDS market is stronger (weaker) than in the opposite direction, then the basis widens (narrows) , or in other words, the CDS spread increases (decreases) with respect to the bond spread.