
As E.U. leaders close in on a remedy for future sovereign crises, it’s not looking very good for buyers of protection on sovereign credits.
Last week, E.U. leaders put in place a new permanent crisis resolution mechanism. The European Stability Mechanism, which will replace the European Financial Stability Facility in 2013, will hold EUR700 billion (USD987 billion) to loan to European countries in dire straits. Of that, only EUR80 billion will be in the form of capital from member countries; the other EUR620 billion will be in the form of callable capital.
While the agreement lays the groundwork for dealing with future crises, it doesn’t stave off the current one. The CDS market has yet to be tested by the default of a large sovereign since taking off about five years ago, noted one credit strategist.
Short of a default, some of the peripheral countries could require loans from the ESM and have their debt restructured. The existing sovereign debt would be considered subordinate to the loan, either from the ESM or the International Monetary Fund.
But would the subordination be considered a credit event? A recent decision by the International Swaps and Derivatives Association’s credit determinations committee seems to say otherwise. The committee recently ruled that no restructuring credit event had occurred because of Ireland’s first draw-down of its loan from the IMF.
That’s bad news for market players buying protection on sovereign countries, in hopes they’ll get paid out if the country goes belly-up. But at least it shines a light on the fact that the definition of “belly up” may be harder to prove in the protection buyers’ favor.
In the meantime, it may be make sense for market players to take the advice of strategists at Société Générale: forego buying protection on sovereign credits, at least as a hedge.