Tuesday, October 18, 2011

Naked Credit Default Swaps Banned In Europe

This afternoon European leaders decided to ban purchases of "naked" Credit Default Swaps on sovereign debt moving forward.  (This does not affect contracts already in place)

What does this mean?  Let's go back to the example I gave over the weekend in, Enter Greece CDS: The Fork In The Road, using homes on the coast of Sanibel Island to make the discussion easier to understand.

A "naked" purchase of CDS means that you do not own the underlying asset.  You are simply speculating that it will fail.

For example, imagine that you went down to Sanibel Island.  You saw the homes sitting on the coast line and you decided to purchase an insurance contract on 3 homes.  Here is the key; you do not own the homes you are purchasing insurance on.  You are simply betting on their destruction.  This is a "side bet" with the insurance company. (Exactly how the derivatives market works)

You make a $300 monthly payment every month, ($100 for each home) and if a hurricane never comes through, you never collect.  But if the homes are destroyed, you collect all the money needed to bring them back to full value.

Now imagine the government caught on to your "sinister" ways of making money off these poor people whose homes were ruined.  You go home for dinner and think about if there is any other way to bet against the value of these homes.  "Aha," you have it.

You knock on a home owner's door that has a for sale sign in his front yard and tell him you have a proposition.  You tell him that you want to borrow the full price he has his home listed for, and that you will pay him back when he sells his home.  However, you will only pay him the price he sells it for.  Believing that his home is undervalued, he takes you up on this bet.

This is the equivalent of shorting the debt of European countries.  Now that the "evil" speculators cannot bet against government debt in the derivatives market, they are going to focus all their attention on the actual debt.  They will borrow bonds today and tell the government they will give them back at the future price.

If the price of the home on Sanibel Island is sold below the asking price, you get to keep the difference.  If the price of the European bond sells for less in 2 months than what an investor borrowed it for today, they get to keep the difference.

Why is this important?

This is going to drive up the interest rates on European bonds.  When interest rates rise it makes it more difficult for the government to finance their current and future monthly payments.  (Think about your mortgage, car loan, and credit card loans all rising)

Other than Greece, whose rates are already in the stratosphere, rates are rising across the board on all European bonds.  The spread between France and German bonds reached a 20 year high this afternoon. (Investors are running from France as the contagion is spreading everywhere)

As discussed in previous CDS analysis, every government action has a market reaction.  Watch the bond yields closely over the next few weeks. (Spain was just downgraded as I type this)  I will continue to update the spread of the contagion as we move forward.

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