Wednesday, 17 February 2010

CDS spreads on spreads

In defence of Greece, I pointed out to a colleague the other day that the cost of a Greek CDS is only 4% for a five year period - meaning that you only need a 0.8% interest premium to make a Greek bond worthwhile, or that the market only gives Greece a 1/125 chance of defaulting each year.

He responded with the valid observation that this is all very well, but who's offering this insurance policy and will they be around to pay it if Greece does default? After all, AIG wasn't.

In fact, the 4% is not the spread between the chances of Greece defaulting and a risk-free bond, as it's commonly presented. It is actually the spread between the chances of a Greek default and an insurance company default.

It's a lot easier for an insurance company to go bust than it was two years ago. Not only have risk conditions deteriorated, but after AIG, Citi and the rest, it would be immensely tough politically to bail out another big insurance company or bank which had issued CDS it could not pay out on. So keep this in mind if you are tempted to buy any CDS coverage [er...this is not investment advice!].

Related: chat from the FT.

Also related (though non-Alphaville members may not have access): who are Greece's CDS counterparties? The rumour is that these are being sold not by international insurance companies, but by GREEK BANKS! How much do you think that insurance policy is worth?

2 comments:

unauth said...

huh? what if it's marked to market daily and collateralized?

Leigh Caldwell said...

And - typically - is it?

This post from Naked Capitalism hints otherwise. Maybe things have changed since that article? I'd be interested in your thoughts on this as I have not worked professionally in this area of finance.