Hedge funds and prop desks have inflated the price of Italian credit-default protection by snapping up illiquid CDS on the sovereign in the wake of poor economic news from Italy. But dealers are now anticipating a liquidity crunch when the bubble bursts because credit protection on sovereigns such as Italy is not frequently traded and the speculators may be caught with positions they can't unload.
The funds are facing a crunch as they look to unwind in-the-money short bond/long protection trades in a market that generally has few buyers, even when prices haven't been pushed out of kilter. And that's where the prices are now: 10-year protection on Italy jumped to 25 basis points last week, from 15 bps two weeks before, to reach the same price as protection on Greek sovereign bonds.
Dealers said players bought protection as credit-default swap spreads started rising on the back of Italy's faltering economy and a loud campaign from the Northern League political party calling for Italy to exit the euro. Funds bought 10-year CDS at 15 bps and have chalked up a paper profit, said one trader, but they need to unwind to realize the profit and it's not clear if they will be able to do that.
"[Funds] have destroyed liquidity in the market," groused a trader at a U.S. house. The situation is symptomatic of a wider lemming-like trend in the credit derivatives market, where speculative accounts seem to think the only good trade is the one every other player is putting on. Funds were also recently pummeled by long equity/short mezzanine trade losses (DW, 5/2) are not learning the lesson, he noted.
Harvinder Sian, strategist at ABN AMRO in London, said Italy should be trading tighter than Greece. "[Italy CDS] was given a nice little kicking after the referenda," he noted. He added fundamentals don't support spreads as wide as 25 bps and although there may be further widening opportunities it will eventually pull in.
