The chart below, calculated by Credit Derivatives Research LLC, shows the counterparty risk index, an unweighted average of the credit default swap spreads of the 14 major financial institutions in which such exposures are largely concentrated. The left-hand scale gives the cost (in basis points) of insuring against default for a five-year term.
The three big spikes on the chart mark the near-failure of Bear Stearns (in March 2008), the Lehman default (September 2008) and renewed concerns over bank safety as financials’ share prices hit their low (in March this year).
Starting last spring, crises had been cropping up at six-monthly intervals but we now appear to have broken out of the cycle and the CRI index sits at the levels of last June.
Within the index, European banks continue to trade with lower CDS spreads than their US counterparts. As Dave Klein of CDR notes, “average European CRI CDS levels stand at 74 bps, one third less than US members’ average of 117bps and 20% less than the current index level of 92bps.”
As far as individual bank names are concerned, Klein points out that HSBC has recently taken over from BNP Paribas as the least risky member of the CRI (the bank trading with the lowest CDS spread) while, amongst US banks, JP Morgan has the lowest CDS spread, followed by Goldman Sachs and Bank of America. Citigroup remains the riskiest name in the index.
What are the implications of this for the exchange-traded product market? Will we now start to see a trend towards greater uncollateralised exposure in ETPs, after 12 months in which there has been a steady trend towards greater collateral backing and diversification of counterparty exposure (through ETF platforms)? And will the ongoing argument about counterparty exposures in swap-based or physically replicated ETFs now die down? So far there are no signs of this, and ETF issuers continue to compete to address concerns in this area. Comstage, for example, has recently announced that it will overcollateralise (to 130%) any swap-related exposure within its funds, using high-quality securities.
As Gillian Tett notes in a column in today’s Financial Times, the concentration of overall (gross) risk in the credit derivatives market amongst the leading banks has actually risen since the AIG bailout last September, and regulators are still finding it difficult to assess whether banks are handling their net risk exposures sensibly.
And, in what sounds like the ultimate reinsurance spiral, banks have become net sellers of protection on sovereign debt, hardly reassuring if one remembers that the banks are themselves propped up by the governments concerned. Lloyd’s, anyone?
So, while the reduction in overall default risk so far this year will come as a reassurance to investors, this is a chart that’s worth keeping an eye on.