How the CDS market could help Greece

By Felix Salmon
May 5, 2010
sober analysis and the bloody riots, one expected artifact of the chaos in Greece has been notable by its absence: fevered finger-pointing at speculators in the credit default swap market.

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Amidst the sober analysis and the bloody riots, one expected artifact of the chaos in Greece has been notable by its absence: fevered finger-pointing at speculators in the credit default swap market.

And it’s now becoming clear why:

Barclays Capital analysts point out in their most recent European Credit Alpha report that Greek government bonds have been trading substantially wider than credit default swaps on the sovereign. This creates large potential returns on negative basis packages, especially if there is a credit event in the near term.

The negative basis between five-year bonds and five-year credit default swaps has recently been as great as 200 basis points. However, the basis can be even greater for a basis packaging combining short-dated credit default swaps and long dated bonds, says the report. The old-style restructuring used in Greek sovereign credit default swaps means that obligations of any maturity up to 30 years out can be delivered into any credit default swap.

In English, what this means is that the spread on Greek bonds is substantially larger than the spread on Greece CDS. As a result, you can theoretically lock in a risk-free profit by buying Greek bonds and at the same time buying credit protection on them: the cost of the protection is lower than the yield on the bonds, and the rest of your coupon payments is pure profit.

This also means that you can’t blame the CDS market for sending Greek bond spreads gapping outwards — if anything, the opposite is the case, and Greek bond spreads are probably responsible for upward pressure on Greek CDS spreads. Once again, if you own Greek debt, the CDS market is your friend: you’re better off buying protection on that debt than you are simply selling your bonds outright.

This trade could also help fund the Greek bailout while at the same time providing a solid bid for Greek bonds. I thought in 2009 and I still think now that governments might want to get involved in this trade: they can start buying up large amounts of Greek bonds, and hedging the credit risk in the CDS market. That would reduce Greek bond yields (an obviously positive outcome), while at the same time providing a high-visibility vote of confidence in the European banking system and the counterparty risk that might lie inside it.

Right now people are scared about the high yields on Greek debt, and that’s causing nervousness in financial markets worldwide. There’s not a lot of money going into the Greece basis trade, because it might be quite expensive if you need to fund it, and borrow the money you’re investing in Greek bonds. But that’s not an issue for someone like the German government.

While lending directly to Greece with one hand, Germany could start lending indirectly to Greece by buying its bonds in the secondary market with the other — and thanks to the existence of the CDS market, they don’t even need to take on any extra credit risk when they do so. It wouldn’t be enough to save the country from its fiscal crisis, a permanent solution to which is still remote. But it would surely help at the margin.

(HT: Alea)

Update: A tipster explains the reasons for the negative basis here: there’s forced selling in the bond market, especially from accounts which aren’t allowed to hold debt which has even one junk rating. Greece is also being tossed out of a few bond indices. So that explains the downward pressure on Greek bonds, which doesn’t exist in the CDS market.


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