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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Well, it would close the basis between CDS and bonds, but who is Germany going to buy the protection from? Its own banks perhaps? That’s an interesting credit option on a credit option given the likelihood of them being toast if Greece goes down. I’m sure I can’t price that and even if it was done, and the basis between CDS and bonds narrowed to zero, what then? Greece is still in all sorts of trouble. Just doing this can’t drive bond spreads back in to where they were at the turn of the year, it just converges them on the CDS.

Posted by drewiepe | Report as abusive

Hey Felix, great point on ‘who’s to blame’ and i always wonder why if something goes down in price, they blame shorts rather than just people ‘selling’ lol…more specifically on the basis, be careful as the basis has widened dramatically (basis traders got crushed a la 2007/8) as ‘voluntary’ restructuring possibilities kept CDS rich to bonds – trade makes me nervous here – take a look at ARG/VENZ curve relative to GREECE and the front-end…keep up the great work in CDS land.

Posted by CreditTrader | Report as abusive

FYI – check Page 2 of this (it is a week or so old but the story is the same on the basis) and this is the basis between 5Y GGBs and Bunds vs GREECE-GER CDS in 5Y – a little clearer…Neg basis means Bonds cheap to CDS e-Bonds-and-CDS-Update

Posted by CreditTrader | Report as abusive

The Ugly Truth About Paul Krugman
So the Nobel laureate opines today thusly:
Consider what Greece would get if it simply stopped paying any interest or principal on its debt. All it would have to do then is run a zero primary deficit — taking in as much in taxes as it spends on things other than interest on its debt. But here’s the thing: Greece is currently running a huge primary deficit — 8.5 percent of GDP in 2009. So even a complete debt default wouldn’t save Greece from the necessity of savage fiscal austerity.
An astute blogger shoots back:

Mr. Krugman your world view is full of debt slavery.

Greece should leave the tyrannical European Union and then if it wishes can devalue their currency but not too much.
I respond:

Precisely correct on Krugman’s worldview. When he utters “the necessity of savage fiscal austerity,” you can almost imagine the fangs emerging from his dracula-like bloodlust. This is the type of mentality which is caused by the ideology of monetarism, i.e. the worship of money as an end unto itself. Thanks for being so forthright as to exhibit your true inner self Mr. Krugman. Bravo.

P.S. The NY Slimes hasn’t seen fit to post my remarks on the venereal pages. I can only take this to understand that I must have violated their abuse policy. Perhaps I was too hard on Count Dracula…

Posted by Thingumbob | Report as abusive

This is preposterous! Greece’s political is in shambles, the trust of its people lost and will not be regained until a new political and economic order is in place. We all know that many respected market observers/player have stated that the US is heading in the same direction.

Perhaps instead of attempting to speculate on financial instruments to get themselves out of this mess the Greeks, as should the Americans, begin to roll up their sleeves and focusing on creating an economy based on real assets vs financial assets.

Posted by csodak | Report as abusive

So could the greek government buy 300 bil notational CDS to effectively solve their problems by defaulting and then cashing in on those CDS? Stick the bondholders and the CDS counterparties lol. Moral Hazard 2.0

Posted by wolphkaat | Report as abusive

This is like telling a junkie to inject his way out of drug dependency. But funny at the same time.

Posted by HBC | Report as abusive