The End of the End of the World Trade

Too much gets made of sovereign credit default swap widening, especially that of the U.S. I’ve made that mistake here in the past once or twice, although more in the dismissive direction (i.e., an "end of the world trade" isn’t very useful if you only get paid out when the world ends). There are many perils in over-analyzing U.S. sovereign CDS spreads, including the following:

  • Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen – I make this point in my AIG post. It follows that extrapolating any default information from wider CDS spreads can be misleading
  • An apples-to-apples comparison of US CDS spreads suggests that $-denominated US CDS (the standard  contract that is quoted in the news is the €-denominated one) should be trading at half the level it is now, perhaps making the recent news a lot less exciting
  • The standard CDS contract is sufficiently complex so that the end-game buyers of CDS can be betting on something much more innocuous than a “default” such as a restructuring of privately negotiated tiny-size debt issuance
  • Sovereign CDS (US included) has actually lagged both rising financial as well as systemic risk and has only now caught up, making the recent move largely expected

More here.

[via FT]