European credit derivatives traders were advising their colleagues at German banks to take it on the chin as the financial crisis in Turkey unfolded last week. German banks, including Deutsche Bank, Commerzbank and Dresdner Bank, are believed to have huge basis risk on commercial loans they have extended to Turkish banks, which they have imperfectly hedged by purchasing credit default protection on Turkish sovereigns. "Sit on it and pray," said a trader at a U.S. bank in London. He noted that if the Turkish banks default without an accompanying sovereign credit event, the German banks could be left with substantial losses. Officials at the three banks declined comment.
If the Turkish government agrees to honor loans from banks that default, German lenders are safe because they will either get paid by the government or, if the government defaults, the credit default protection will kick in, a trader explained. Traders at rival banks were unable to put a dollar size on the exposures involved because credit protection is often bought and sold in the direct market.
Three-year credit protection on Turkey rocketed to a peak of 950 basis points/1,050bps on Wednesday from 600bps/650bps the previous Friday. It came back down 100bps on Thursday as the market stopped panicking. Traders said only one trade, one-year and nine-month protection at 800bps, went through the market last week.
The Turkish lira devalued approximately 30% against the dollar on Thursday from Wednesday's close of TRL687,200 after the prime minister, Bülent Ecevit, described the break down of anti-corruption talks as a crisis. Caroline Gorman, emerging markets analyst at 4CAST in London, said, "It was a political gaffe of the highest order." But she does not expect Turkey to default on its foreign debt and is confident the International Monetary Fund will continue to the back the sovereign.
