Let Europe kill municipal CDS

By Cate Long
October 31, 2011

The solution to Greece’s debt crisis that Europe’s leaders announced on Thursday has market participants and commentators howling. It includes a provision that changes long-established rules for credit-default swaps mid-game. Mike Dolan, Reuters’ Investment Strategy Editor in Europe, said this:

For all the ifs and buts about the latest euro rescue agreement, one of its most profound market legacies may be to sound the death knell for sovereign credit default swaps — at least those covering richer developed economies.

I’d suggest that death knell just rang for U.S. municipal credit-default swaps (CDS), too. They’ve recently been on their last legs amid collapsing volumes, but actions in Europe just might have delivered the deathblow.

Credit-default swaps play an arcane role in financial markets. Firms allegedly buy them for protection against the default of bonds they hold in their portfolios. For example, if XYZ Investment Group owned $10 million worth of Greek government bonds that matured in 10 years (GGGB10YR:IND) and the Greek government couldn’t pay their obligations, then the seller of the CDS would step in and pay the CDS owner. Think of the CDS seller as a guarantor or insurance provider of sorts.

CDS are marketed as protection against the risk of default of the cash bond that they reference. Contrary to standing convention though, when the announcement was made that Greek bondholders would be asked to take a 50 percent haircut (or markdown) on the value of their bonds, the CDS governing group announced they would not be triggered. Their rationale was that the bond swap would not be compulsory and that CDS sellers would not need to make payouts to make up losses. Here is how a twitter user responded:

amb5160 @amb5160 amb5160 the real story today is that CDS, a multi billion (trillion??) dollar asset class is GONE in one day! no more quotes on bberg. insanity

Why invest in insurance if the insurer says no payment is necessary because we have new conditions? It’s easy to understand the outrage.

How does this relate to municipal credit-default swaps? In June Lisa Pollack, who worked at the time at Markit, a CDS market data provider, posted the following table of municipal CDS. Her data came from the DTCC CDS Trade Information Warehouse.

When I checked today the amounts outstanding had shrunk dramatically to a gross notional total of $1.2 billion from approximately $28.5 billion in June 2011. In June I wrote about Bill Lockyer, Treasurer of California, investigating the banks over their CDS dealing.  I’m not sure if Lockyer’s efforts lead to the shrinkage of the market but I pointed out in September that the banks issuing municipal CDS had worse credit quality than the states for which they were writing insurance policies. I’ve updated the comparative chart below.


Only JP Morgan and Citibank have better credit qualities than the states they insure, though Goldman Sachs has a better credit profile than Illinois, which is not saying very much at all.

I might suggest that given the small amount of CDS outstanding and the miminally stronger credit quality of the banks, maybe we should just let this whole market run off. In other words, let it disappear in the night. It’s hard to see much of a future here. The repudiation of CDS for Greek bonds is the final straw. Let Europe kill off the municipal CDS market.

One comment

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I was under the impression that ISDA had not made a ruling yet on whether the haircut would be considered a default event triggering payment. If they do not it, I agree it will be a disaster for the cds market.

Posted by justinv | Report as abusive