USA Credit Risk Now Worse Than 2011

Understanding the complexities of the sovereign CDS market is tricky... so we are constantly bemused by the mainstream media's constant comment on it as if they have a clue. The fact is that the USA CDS market is indicating a higher risk of imminent technical default now than in 2011. As we explained in painful detail previously, you cannot compare a 71bps (+8 today) 1Y USA CDS spread to a 1200bps JCPenney CDS spread - they are apples and unicorns. Having got that off our chest, the fact that the cost of 1Y protection is at 2011 extremes (implying around a 6.5% probaility fo default) and has been higher (inverted) relative to 5Y now for 3 weeks is a clear indication that investor anxiety is very high this time (just look at T-Bills!).


 


The absolute level (given the lower levels of interest rates and EUR forwards) and the inversion (size and period) make this far more "risky" a period than in 2011...



 


and the net notional (think open interest) has exploded...



 


And in order to help a few people out, here is Barclays with a primer on USA CDS...


FAQs on USA Sovereign CDS


Overview


The current stalemate over raising the debt ceiling has renewed interest in USA sovereign CDS. While still at low absolute levels, spreads have been moving wider, particularly at the front end, with 1y CDS going from 24bp on September 19 to 70bp (mid) on October 9. Although we believe the probability of a technical default is very low, we think it is important for investors to understand the basics of the USA sovereign CDS contract in the event that CDS were to trigger. To that end, we provide a brief list of FAQs on USA sovereign CDS.


FAQs


What type of contract is USA sovereign CDS?
USA CDS is a Standard Western European Sovereign (SWES) contract. It is denominated in euros. For more details on SWES, please refer to the latest physical settlement matrix on the ISDA website.


How much USA CDS is outstanding?
Using DTCC data, as of October 4, 2013, the net notional outstanding of USA CDS was $3.63bn. Investors can monitor the data using the CDNO function on Bloomberg.


Are there any restrictions on buying USA CDS?
The European Commission (EC) ban on naked CDS shorts applies only to the member states of the European Union, so the EC ban would not affect an investor’s ability to buy USA CDS.


What credit events are applicable to USA CDS?
Under SWES, there are three potential credit events: Failure to Pay, Repudiation/Moratorium, and Restructuring. Most of the focus currently appears to be on the Failure to Pay trigger. A Failure to Pay only refers to a failure to make payments on debt (i.e., borrowed money) obligations, not on payments in general (for example, to vendors, employees, etc.).


What would happen if one or more rating agencies determined that the US was in default?
Actions by the rating agencies are not considered a credit event for the purposes of CDS. The determination of whether a credit event had occurred would be made by the Americas ISDA Determinations Committee (DC).


How much debt is due to mature in the period surrounding the October 17 debt ceiling deadline?
$120bn of debt is scheduled to mature on October 17. Another $93bn is scheduled to mature on October 24. The Treasury is expected to roll over the debt. However, as the Bipartisan Policy Center recently noted, “One risk is that buyers of government debt will be less likely to participate in Treasury auctions and, for those that continue to participate, more likely to demand higher interest rates, increasing the cost of servicing the existing debt”[1].


When is the first significant interest payment due following the October 17 debt ceiling deadline?
According to our rates strategists, the first real test from a coupon payment standpoint will be the $6bn in interest payments due October 31. Please see pages 2-3 of Global Macro Daily, October 2, for more details.


Is there a grace period for US Treasury interest payments?
US Treasuries do not have a specified grace period. However, there is a 3 business day grace period for Failure to Pay specified in the ISDA definitions, which would apply.


What is deliverable into USA CDS?
The ultimate determination as to what is deliverable would be made by the DC. However, based on our interpretation of the ISDA definitions, we believe US Treasury bills, notes, and bonds would be deliverable into USA CDS. We also believe the current cheapest-to-deliver (CTD) bonds among US Treasuries are the 2.75s of 8/15/42 (ISIN US912810QX90) and the 2.75s of 11/15/42 (ISIN US912810QY73), which closed on October 8 at $82.90 and $82.77, respectively. However, this is not a legal opinion, and clients should do their own due diligence. In addition, the final settlement price for USA CDS following a Failure to Pay event is determined through the ISDA auction process, which will reference a portfolio of deliverables, not just the cheapest to deliver obligation.


Are inflation-linked bonds deliverable?
Deliverability of inflation-linked bonds is complicated by the “Not Contingent” deliverability requirement, basically meaning that the principal of a bond cannot by reduced in any other way than by payment. Depending on the specific fact pattern, this could prevent a bond from being deliverable altogether or make it deliverable only for the nominal, “non-inflated” principal.


Are STRIPs deliverable?
Based on previous pre-ISDA DC decisions, we believe it is unlikely that STRIPs (IOs/POs) would be deliverable, as “components of bonds” have historically not been considered to be direct, deliverable obligations of the reference entity. As an example, when Fannie Mae and Freddie Mac defaulted in 2008, their stripped, principal-only obligations were deemed to be not deliverable. But again, this is not a legal opinion.


Is there any other debt that would be deliverable?
In addition to US Treasuries, debt obligations of US government agencies that benefit from a “Qualifying Guarantee” (QG) would be deliverable, as per the ISDA definitions. The QG requirement is generally very restrictive, excluding any guarantee that is not evidenced by a written instrument or that is capable of being released in any other way than by payment. Entities that carry (implicit or explicit) guarantees but do not satisfy the strict QG requirements would not be deliverable obligations. With that in mind, entities such as Fannie Mae and Freddie Mac, which benefit from implicit guarantees, are unlikely to be deliverable.


How does the CDS auction process work?
Please see CDS Auction and Settlement Dynamics for more information on the CDS auction process.


When would the exchange rate for the CDS auction be fixed?
The DC has discretion in deciding when the FX rate is taken. That said, it usually picks the mid-level rate published by Reuters at 4pm the day before the auction. The day for picking the FX rate forms part of the Auction Settlement Terms (AST), published ahead of the auction. Despite USA CDS being denominated in EUR, given that the pool of deliverables would be dominated by USD, we find it likely that any auction would be held in USD. We saw this for the case of the credit event for The Hellenic Republic, where the auction was held in EUR, despite the majority of CDS trades being denominated in USD.


What factors could affect the final settlement price on CDS?
One consideration for investors who just buy USA CDS protection (and do not own the cheapest to deliver obligation) is what might happen to the CDS payoff in the event that rates rally sharply prior to the CDS auction. It is worth remembering that rates rallied sharply following the downgrade of the USA sovereign rating by S&P in August 2011. If a technical default triggered a similar reaction (i.e., a flight to quality), recovery could be higher, in which case the CDS payoff would be lower than expected. In addition, even without a rally in rates, the fact that the auction process references a portfolio of deliverables, not just the cheapest to deliver obligation, could also make the overall payoff lower than expected for those who do not own the cheapest to deliver.


We would imagine that the pool of deliverables could be very large, with many bonds included that are not well understood by the auction participants. This could make them bias their prices in the auction down, so as to compensate for the uncertainty of risking delivery of a “worse-than-expected CTD” bond.


Another consideration for investors who own CDS protection only and do not hedge the currency risk is the potential effect of a sharp rise in the US dollar vs. the euro. Since the naked short position in USA CDS is denominated in EUR, any decline in the EUR/USD exchange rate would lower the eventual payoff in USD terms.


 


Please do not comment on default risk or CDS until you have read this...

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