Wednesday, April 27, 2011

Sovereign Recovery Swaps? What Are They?

 Sovereign recovery swaps are “bets on how much money will be retrieved in a default.”  The first trades took place last year.  (See “Default risks spark interest in recovery swaps trading,”

Why did sovereign recovery swaps arise?

They arose as “European policymakers have moved to curb trading of credit default swaps, the established way to hedge against the risk of a debt restructuring.” 

These new tools are gaining more publicity as the eurozone moves back into a crisis mode concerning the sovereign debt of their troubled constituents.  This is especially coming to the fore as Greece struggles over its failure to achieve fiscal targets set to combat earlier financial market unease. 

Greek debt reached euro-era high interest rates yesterday…as did the interest cost of Ireland and Portugal debt. 

Calls are increasing for a restructure of the debt of Greece.

So, financial market participants want a way to protect themselves against unfavorable movements in debt prices…given the wisdom of “policymakers” to curb trading in other instruments that might do the same thing.

With recovery swaps, an investor can bet on the level of “haircut” that might take place on any restructuring. 

A credit default swap might have a fixed recovery rate in the case of a restructuring.  If the recovery rate is lower than this fixed rate, the investor makes up the shortfall through the purchase of the recovery swap. 

Of course, there are risks associated with these tools: the “credit event” that triggers the contract must be due to a failure of the nation to meet obligations…it must be an “official” default.

The point I want to emphasize, however, is how quickly financial markets respond to fill a need when restrictions or potential restrictions are devised to restrict or constrain other means of achieving the same objective. 

Policymakers just don’t get it! 

In their efforts to fight “past wars”, policymakers invent new rules or regulations to combat behavior the policymakers deem to be inappropriate or unacceptable.  In doing so, these policymakers just chase the participants in financial markets to move elsewhere or to create new financial innovations.

Two points here:

First, in this electronic age, there is little that regulators can do to establish the “control” that they want because it is so easy for one form of “information” to be transformed into another form;

And, second, once financial innovation is in place, there is no going back to an earlier time.

Policymakers just don’t seem to understand these two points.

Furthermore, another fear that the policymakers have is that these financial innovations can be used for “speculation”. 

For example, when the government of Greece announced its latest budget results, the cost of borrowing immediately went up and the price of credit default swaps and sovereign recovery swaps rose.  Some government officials claimed that unconscionable speculators betting against the government caused these movements. 

This, of course, is the basic visceral response of leaders faced by market movements unfavorable to the direction they are leading their organization.  I don’t know how many chairman I have known or worked for that have claimed that ‘the market just doesn’t understand us” and “speculators are hitting us just when we are down.”

I was less worried the other day when Standard & Poor’s said that the outlook for the debt of the United States was negative than I was about the response of President Obama saying that the bond markets were being impacted by speculators.  Oh, my!

Policymakers must eventually deal with the problems they have created.  Many governments in Europe have been dealing with the problems they have created for many months now, yet have not faced their real issues head-on. 

Policymakers must eventually realize that they cannot resolve these problems by changing the rules and regulations or by trying to buy time with “quick-fix” bandages.  The eurozone has been attempting to “get around” the solution to the problems of its members with short-term “fixes” and have not dealt with the fundamentals of the situation.

Policymakers must eventually understand that in the modern world information spreads and that governments cannot respond to crisis by pointing the finger in another direction, blaming “speculators” or “terrorists” or some other agent that is questioning their leadership.  The governments of the eurozone must ultimately take responsibility for their actions and do something about it.

Keep your eye on markets and market innovations.  Don’t impose your own view on these market changes but dig as deeply as you need to in order to determine what the market is trying to tell you.  The markets may not always be right, but they do contain information we need to consider in making our own decisions.

The news today…there is going to have to be a debt restructuring within the eurozone.  Financial “band-aids”, government bailouts, and new rules and restrictions are not going to do the job.  Will it be Greece…or will it include Ireland?  Will it extend to Portugal…and then to Spain?  And, maybe others will be impacted as well?

The betting is getting hotter!

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