Credit Markets Bet on Pakistan Default

Amidst a flurry of activity by Pakistani government to seek bailout from friendly nations and possible resort to IMF loans, the credit markets are betting that Pakistan will most likely default on its sovereign debt. Pakistan's sovereign debt now has the dubious distinction of being the riskiest, surpassing Argentina's sovereign debt.

According to The News, the price for insuring $10 million worth of Argentina's debt in September stood at $788,000 while the price to insure the Government of Pakistan-guaranteed debt skyrocketed to $950,000, something that has never happened before.

As recently as June this year, Pakistan sovereign debt credit default swaps (CDS) traded at 530 basis points in Hong Kong, meaning it cost $530,000 a year to protect $10 million of Pakistan's debt from default for five years. A jump from 530 to 950 basis points means the risk of default by Pakistan has almost doubled since June, 2008. The risk has particularly shot up since President Musharraf left office in August, 2008. It should be noted that Pakistan CDS traded at a record low of 146 basis points around the time of the February elections.

Credit-default swaps are an indicator of the cost of bond "insurance" that varies with the risk of bond default. Credit default swaps are privately traded derivative contracts usually bought by bond holders from CDS issuers like AIG, Ambac, FGIC, and MBIA and other entities. Like other derivatives, CDS are not regulated by government agencies. The CDS issuers are expected (not gauranteed or back-stopped by governments) to reimburse bondholders in case the bond issuing companies or governments default. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year. The buyers of CDS do not have to be bondholders. Any one can buy a CDS to bet on the probability of default by debt issuers. Once issued, the credit default swaps are bought and sold like any other contract. Many of these derivative contracts were bought to bet that the housing bubble would pop and many homeowners would default on their mortgages. That is exactly what happened this year.

Lately, credit default swaps have come under heavy criticism for being the main contributor to the unfolding financial crisis around the world. Since credit default swaps are unregulated derivatives, they can be issued by any one. Many thinly-capitalized entities are in the business of issuing CDS to make a lot of money fast. In its recent issue, Fortune magazine reports that Wachovia and Citigroup are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some debt. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

Fortune compares the CDS market with casino gambling. It says that when you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. The ease and low cost of CDS encouraged a lot of lending and borrowing that would not have occurred otherwise. Both the lenders and borrowers believed they could easily transfer risk to a third party at relatively low cost.

The result of the rapid growth in credit default swaps is a $54.6 trillion problem. In spite of the massive global government intervention, including US government's takeover of AIG, the biggest CDS player, this huge problem will take considerable time and money to unwind. Meanwhile, it will get a lot harder for Pakistan and other economically troubled governments such as Ukraine, Kazakhstan, and Argentina get credit from any one other than the International Monetary Fund. Such credit usually comes with tough conditions and micromanagement of country's budget, taxes, spending and economy by IMF officials.

Related Links:

Pakistan Likely to Avoid Default

The $55 Trillion Question

Pakistan's Debt Riskiest

Can Pakistan Avoid IMF Bailout?


Riaz Haq said…
Pakistan's CDS's rising again, according to Daily Times:

KARACHI: As uncertainty digs further in the Pakistan politics, country’s international sovereign yields and Credit Default Swap (CDS) are on the rise again, requiring higher premium for investments.

In Pakistan’s case, both the indicators have been again showing a persistently rising trend off late. Eurobond yield (maturity 2016) is currently edging 14.5 percent while CDS is already hovering around 1,000bps mark.

Both peaked out during Oct-Dec 2008 when Pakistan was near default (yield went as high as 26.2 percent while CDS as 5,105bps or 51 percent) while bottomed out in April 2010. This Eurobond+CDS based RRR however does not include currency risk premium (as sovereign bonds are mostly USD denominated).

Amongst other country risk premium measures, Eurobond yield-plus-CDS can be used to gauge foreign investor’s required rate of return (RRR) for a particular country.

Therefore, adding currency risk premium scales foreign investor’s RRR even higher thereby adjusting values of either stocks or fixed income securities downwards. It is quite evident in the current scenario that with country’s risk going up as reflected by rising Eurobond yield and default risk premium (even though liquidity of the two is very low, frequently causing wild changes in yields as well as default swaps), foreign outflows become more persistent.

Pakistan’s Eurobond yield, which incorporates sovereign investment risk, and CDS, which entails insurance of a country’s default on its foreign bonds, has been once again on the rise.

A quarterly basis probe over the last 4 years reveals that whenever foreign investor’s RRR goes higher than that of the local, it causes faster outflows than usual, underpinning increased volatility in capital markets. If we see the first RRR graph alongside, it shows whenever foreigner’s RRR was at premium to local’s (excluding currency risk premium) it caused severe outflows from country’s financial markets (second RRR graph).

On the other hand, when both the required returns collide (as in the case during 1Q, 2Q and 3Q of 2011, despite worsening macros and heightened political risk) there was relatively low foreign activity at the markets. It also gives birth to a thought whether these foreign flows are all real. But largely, such behaviour of the investor hits logic as foreign investor incorporates currency risk that jacks up overall required returns when there is greater volatility in the currency market (as in Pakistan’s case now).

The current foreign RRR is therefore on the rise again (24 percent based on Eurobond yield+CDS only) and so are foreign outflows, while local average RRR stands at 20 percent (10-yr PIB yield+market risk premium). Thus, foreign outflows will continue till both the RRRs collide once again, which is of course largely contingent upon overall political as well as macro economic risks in the country.\12\24\story_24-12-2011_pg5_1

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