Europe Economy

Loss of Confidence in CDS Means Trouble: Economist

The agreement on the size of the haircut on Greek debt banks will take could have serious consequences for all the so-called PIIGS according to Carl Weinberg, the chief economist at High Frequency Economics.

The problem for Weinberg is the International Swaps and Derivatives Association’s (ISDA) decision that the voluntary haircut offered by the banks on all Greek government debt was not a credit event that would trigger credit default swaps.

Credit default swaps are supposed to protect investors against losses when those issuing bonds do not pay back the principle in full, and the Greek example is likely to add to selling of other peripheral debt, according to Weinberg.

“After a ruling like this, people holding CDS on Italian, Spanish and Portuguese bonds could reasonably doubt that those contracts offered insurance against anything,” he said.

Without the protection of CDS against default Weinberg expects yields to rise, adding to the problems of the euro zone debt crisis.

“Remove the credibility of the insurance, and the market price of CDS tells us investors want 4.5 percent yields on top of yield of the underlying security to hold 10-year Italian debt,” said Weinberg in a research note on Monday.

Not all bonds are protected by CDS and Weinberg says not all investors believe that all of the insurance value of CDS has been wiped out by the IDSA’s ruling.

He does though think Italian yields are heading towards 10 percent, not lower.

“For now, yields on PIIGS issued bonds will continue to rise. We predict safe-haven trades into safe bonds will continue. Yield curves will flatten,” he said.

“However, yields cannot fall forever. Risk of a catastrophic correction in prices for safe bonds hangs over the markets” said Weinberg.

“Then, higher yields and capital losses on bond holdings become inevitable,” said Weinberg.