facilegestures

Here we are. Again. The €, has once again been rescued, the crisis once again been resolved. Except for, it has not.

Wednesday night’s comprehensive solution provided brief rocket fuel to every risky asset around with the sole exception of precisely those, which it was designed to support. Italian 10y yields are  14basis points higher now than on Wednesday before the saviors gathered.

At the same time the foggy compromise reached with bank representatives so far lacks any details. It promises to become an operational nightmare. What is becoming clear however, is, that should it be implemented as advertised (which remains doubtful) it may very well end the market for sovereign CDS, with a number of unintended consequences. Imagine you were a prudent hedger, reducing exposure to Greece when the crisis first emerged in late 2009 by purchasing insurance against default via a CDS instead of outright selling the bond, which you likely had on your banking book thus avoiding a writedown.

Now, you paid rather expensive insurance for 3 years, only to see it NOTpay out on a 50% loss, because policy makers call it ‘voluntary’?

IF market participants start to realize that sovereign CDS are not going to provide protection when it is most needed, the consequences could be severe. The only way to reduce your exposure would then be to sell crisis-plagued countries’ bonds in the market, putting further upward pressure on yields which is clearly not what policy makers aim to achieve.

The insurance solution to provide leverage is questionable as well. Look at a country in crisis – 10y bonds trading at 60%, and now they auction off a bunch of new bonds with a 20% first loss protection provided by the EFSF. The hope is that investors would be drawn to the newly issued bonds because of this precious piece of insurance. But would you rather buy at par with a 20% guarantee and risk losing 80, or get the old bond in the secondary market at 65? I expect the required  yield on the new/insured bond might have to be higher than most currently anticipate.

Looking forward to an interesting discussion as the details start to emerge.