Who/What is Driving European Sovereign Spreads?

The center of our global financial crisis squarely rests upon the Euro-zone in general and a number of peripheral sovereign states specifically. The movement in spreads within this market are often vicious.

The  European Central Bank has thrown the kitchen sink in the form of its 3-year LTRO (long term refinancing operation) at the massive debt problem. The LTRO aside, do you get the sense that there is a far greater force at work behind the scenes driving these markets? I do. Who and what are really driving spreads within the Euro-zone?

Let’s navigate as the Journal of International Money and Finance addresses this critically important topic in its April 2012 issue.

The Rouen Business School in France highlights the Journal’s work in a recent release:

April 2012 — A paper published in this month’s issue of the Journal of International Money and Finance challenges the widely-held belief that the relatively small credit default swaps (CDS) market cannot influence bond spreads in countries with long-established and large sovereign debt markets, such as France.

By using a radically innovative methodology to study a sample of different European Union member countries during the post-Lehman Brothers’ bankruptcy period, Anne-Laure Delatte of Rouen Business School, Mathieu Gex of the University of Grenoble, and Antonia López-Villavicencio of the University of Paris North, found evidence that the relationship between CDS premiums and bond spreads is not linear. This means that in times of market distress the much smaller CDS market could drive up the bond interest rates of sovereign nations, amplifying the crisis. The study showed that no country is safe from this perverse effect.

While there have been previous studies examining CDS and bond rates, all make the hypothesis that everything happens in exactly the same way no matter what the state of the market. This is the first study that factors in an exception to this unrealistic presumption.

Credit default swaps are a derivative financial product related to an underlying asset, in this case a sovereign bond. The CDS is intended to act as an insurance product allowing buyers to hedge against the default risk of any entity. Normally, the higher the risk of default, the higher the insurance premium – not the other way around.

Yet, counterintuitive findings from this paper reveal that the insurance premium actually influences the risk of default when market uncertainty is high. The higher the insurance premium, the higher the bond rate (i.e. the financing conditions of sovereign states). Based on these findings, the researchers conclude that the CDS are used to speculate against the deteriorating conditions of sovereign states and have a very perverse, self-fulfilling effect.

“This is a scientific argument in favor of a strong regulation of this market,” said Delatte. “Unfortunately the ban on naked CDS (without holding the underlying asset) adopted by the European parliament to be applied in November 2012 isn’t the ideal solution because it can easily be circumvented by market operators.”

Delatte posits that it could also give a false impression of security in a market that is completely opaque.

“Today transactions occur over-the-counter and 80 percent of them happen between five major players,” said Delatte. “This market needs more transparency. For this to occur we must centralize it, establish clearing houses and standardize contracts. This will allow regulators to have a complete vision of what’s really happening in this market, and to intervene if necessary. All of the tax efforts we’re currently making in developed countries to balance the budget are very harmful at the socioeconomic level. This massive effort could be ruined by financial speculation.”

No surprise, but obviously very troubling to think that a handful of players (Goldman, JP Morgan, et al) are moving the markets via CDS and blindly creating massive turmoil across our entire global financial landscape.

All part and parcel of the oligopoly disguised as Wall Street circa 2012.

About Larry Doyle 522 Articles

Larry Doyle embarked on his Wall Street career in 1983 as a mortgage-backed securities trader for The First Boston Corporation. He was involved in the growth and development of the secondary mortgage market from its near infancy.

After close to 7 years at First Boston, Larry joined Bear Stearns in early 1990 as a mortgage trader. In 1993, Larry was named a Senior Managing Director at the firm. He left Bear to join Union Bank of Switzerland in late 1996 as Head of Mortgage Trading.

In 1998, after 15 years of trading and precipitated by Swiss Bank’s takeover of UBS, Larry moved from trading to sales as a senior salesperson at Bank of America. His move into sales led him to the role as National Sales Manager for Securitized Products at JP Morgan Chase in 2000. He was integrally involved in developing the department, hiring 40 salespeople, and generating $300 million in sales revenue. He left JP Morgan in 2006.

Throughout his career, Larry eagerly engaged clients and colleagues. He has mentored dozens of junior colleagues, recruited at a number of colleges and universities, and interviewed hundreds. He has also had extensive public speaking experience. Additionally, Larry served as Chair of the Mortgage Trading Committee for the Public Securities Association (PSA) in the mid-90s.

Larry graduated Cum Laude, Phi Beta Kappa in 1983 from the College of the Holy Cross.

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