Wednesday, October 22, 2008

Credit Markets Expecting Pakistan Default

Amidst a flurry of activity by Pakistani government to seek bailout from friendly nations and possible resort to IMF loans, the credit markets are betting that Pakistan will most likely default on its sovereign debt. Pakistan's sovereign debt now has the dubious distinction of being the riskiest, surpassing Argentina's sovereign debt.

According to The News, the price for insuring $10 million worth of Argentina's debt in September stood at $788,000 while the price to insure the Government of Pakistan-guaranteed debt skyrocketed to $950,000, something that has never happened before.

As recently as June this year, Pakistan sovereign debt credit default swaps (CDS) traded at 530 basis points in Hong Kong, meaning it cost $530,000 a year to protect $10 million of Pakistan's debt from default for five years. A jump from 530 to 950 basis points means the risk of default by Pakistan has almost doubled since June, 2008. The risk has particularly shot up since President Musharraf left office in August, 2008. It should be noted that Pakistan CDS traded at a record low of 146 basis points around the time of the February elections.

Credit-default swaps are an indicator of the cost of bond "insurance" that varies with the risk of bond default. Credit default swaps are privately traded derivative contracts usually bought by bond holders from CDS issuers like AIG, Ambac, FGIC, and MBIA and other entities. Like other derivatives, CDS are not regulated by government agencies. The CDS issuers are expected (not gauranteed or back-stopped by governments) to reimburse bondholders in case the bond issuing companies or governments default. A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year. The buyers of CDS do not have to be bondholders. Any one can buy a CDS to bet on the probability of default by debt issuers. Once issued, the credit default swaps are bought and sold like any other contract. Many of these derivative contracts were bought to bet that the housing bubble would pop and many homeowners would default on their mortgages. That is exactly what happened this year.

Lately, credit default swaps have come under heavy criticism for being the main contributor to the unfolding financial crisis around the world. Since credit default swaps are unregulated derivatives, they can be issued by any one. Many thinly-capitalized entities are in the business of issuing CDS to make a lot of money fast. In its recent issue, Fortune magazine reports that Wachovia and Citigroup are wrangling in court with a $50 million hedge fund located in the Channel Islands. The reason: A dispute over two $10 million credit default swaps covering some debt. What's most revealing is that these massive banks put their faith in a Lilliputian fund (in an inaccessible jurisdiction) that was risking 40% of its capital for just two CDS. Can anyone imagine that Citi would, say, insure its headquarters building with a thinly capitalized, unregulated, offshore entity?

Fortune compares the CDS market with casino gambling. It says that when you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. The ease and low cost of CDS encouraged a lot of lending and borrowing that would not have occurred otherwise. Both the lenders and borrowers believed they could easily transfer risk to a third party at relatively low cost.

The result of the rapid growth in credit default swaps is a $54.6 trillion problem. In spite of the massive global government intervention, including US government's takeover of AIG, the biggest CDS player, this huge problem will take considerable time and money to unwind. Meanwhile, it will get a lot harder for Pakistan and other economically troubled governments such as Ukraine, Kazakhstan, and Argentina get credit from any one other than the International Monetary Fund. Such credit usually comes with tough conditions and micromanagement of country's budget, taxes, spending and economy by IMF officials.

Related Links:

Pakistan Likely to Avoid Default

The $55 Trillion Question

Pakistan's Debt Riskiest

Can Pakistan Avoid IMF Bailout?


Riaz Haq said...

Here's a recent news report regarding Aziz's comments on current global financial crisis:

Former prime minister Shau kat Aziz accused the International Monetary Fund on Thursday of failing to show leadership during what he described as a "historic" global financial crisis.

As world leaders met to shore up distressed financial institutions, Mr Aziz charged that "this global institution which is supposed to look at everything going on was not even in the room where meetings are going on."

Speaking at an international business conference in Manila, the former Citigroup banker said interest rate cuts, recapitalisation of banks and liquidity injections, while helpful, would not solve the problem.

"The very fabric of the global financial system is under threat," Aziz said.

Mr Aziz said there was a need to boost the IMF's regulatory powers and create a more powerful body.

"The world is becoming increasingly specialized," he said, adding that existing systemic threats beyond the agency's traditional monetary policy role must be addressed. "A robust regulatory regime must touch all the stakeholders," he said, with reference to the credit rating agencies that have come in for criticism amid the crisis.

Riaz Haq said...

Here's a Dawn story about the duplicity of Pakistan's "democratic leaders" published Jan 16, 2009:

ISLAMABAD: While publicly it criticizes former President Musharraf for the present economic mess, the government in its official documents has appreciated the economic policies of the previous regime that became a strong base for seeking loans from multilateral donors and friends of Pakistan.

The PPP-led coalition partners have been blaming Musharraf regime in public speeches for fudging economic figures to paint a rosy picture, while its overall policies pushed the country into economic crisis.

The letter of intent (LoI), on the basis of which, Pakistan sought the much-needed $7.6 billion bailout package from the International Monitory Fund (IMF), has bit by bit appreciated the Musharraf policies since 2000.

During the past one decade (1999-2007), the LoI says Pakistan’s economy witnessed a major economic transformation from substantial increase in the volume of gross domestic product (GDP) to greater international trade.

Talking to Dawn on Thursday former Finance Minister Ishaq Dar said whatever he said about the health of economy was based on the balance sheet existed on March 31, 2008. He said the balance sheet was dully approved by the then cabinet headed by Prime Minister Syed Yousuf Raza Gilani.

He said no body denied the contents of the balance sheet. The focus of the previous economic policy was on promotion of consumerism without supporting the industrial base.

Apparently not willing to agree with the LoI contents, he said though he has a different view of the past economic growth but quickly added the same was destroyed in the last 15 months of the military led dictator.

An official source requesting not to be named said the economic wizards in the finance ministry are not politicians to make only speeches but they have to look into ground realities. ‘We reported to IMF whatever is factual and based on evidence,’ the official added.

The LoI said the country’s real GDP increased from $60 billion in 2000-01 to $170 billion in 2007-08 with per capital income rising from under $500 to over $1000. During the same period, the volume of international trade increased to nearly $60 billion from $20 billion.

For most of this period, real GDP grew at more than 7 per cent a year with relative price stability. The improved macroeconomic performance enabled Pakistan to re-enter the international capital markets in the mid-2000s. Buoyant output growth, low inflation, and the government’s social policies contributed to a reduction in poverty and an improvement in many social indicators.

Former Finance Minister Dr Salman Shah told this scribe the government has made the 170 million people fool while telling them pack of lies in the past nine months about the economic policies of the Mushrraf regime.

He said that as the present government acknowledged in black and white, the impressive past growth made their way easier to make access to the new facility of the IMF for emerging markets hit by the crisis to support the balance of payment problems.

Had growth not been achieved, Pakistan would have to apply for other long term IMF financing facilities like poverty reduction, structural adjustments etc, Shah said adding government should tell truth to the nation if they have confidence.

‘The recruitment made so far for running the finances of this country is very depressing. This shows this government has neither commitment nor capabilities to take the country out of the current crisis,’ Dr Salman said.

Riaz Haq said...

Here's an excerpt from Michael Lewis's The Big Short on how Dr. Michael Burry made a fortune by buying credit default swaps (CDS) to bet against the sub-prime mortgages:

“You just have to watch for the level at which even nearly unlimited or unprecedented credit can no longer drive the [housing] market higher,” he wrote. “I am extremely bearish, and feel the consequences could very easily be a 50% drop in residential real estate in the U.S.…A large portion of current [housing] demand at current prices would disappear if only people became convinced that prices weren’t rising. The collateral damage is likely to be orders of magnitude worse than anyone now considers.”

On May 19, 2005, Mike Burry did his first subprime-mortgage deals. He bought $60 million of credit-default swaps from Deutsche Bank—$10 million each on six different bonds. “The reference securities,” these were called. You didn’t buy insurance on the entire subprime-mortgage-bond market but on a particular bond, and Burry had devoted himself to finding exactly the right ones to bet against. He likely became the only investor to do the sort of old-fashioned bank credit analysis on the home loans that should have been done before they were made. He was the opposite of an old-fashioned banker, however. He was looking not for the best loans to make but the worst loans—so that he could bet against them. He analyzed the relative importance of the loan-to-value ratios of the home loans, of second liens on the homes, of the location of the homes, of the absence of loan documentation and proof of income of the borrower, and a dozen or so other factors to determine the likelihood that a home loan made in America circa 2005 would go bad. Then he went looking for the bonds backed by the worst of the loans.

It surprised him that Deutsche Bank didn’t seem to care which bonds he picked to bet against. From their point of view, so far as he could tell, all subprime-mortgage bonds were the same. The price of insurance was driven not by any independent analysis but by the ratings placed on the bond by Moody’s and Standard & Poor’s. If he wanted to buy insurance on the supposedly riskless triple-A-rated tranche, he might pay 20 basis points (0.20 percent); on the riskier, A-rated tranches, he might pay 50 basis points (0.50 percent); and on the even less safe, triple-B-rated tranches, 200 basis points—that is, 2 percent. (A basis point is one-hundredth of one percentage point.) The triple-B-rated tranches—the ones that would be worth zero if the underlying mortgage pool experienced a loss of just 7 percent—were what he was after. He felt this to be a very conservative bet, which he was able, through analysis, to turn into even more of a sure thing. Anyone who even glanced at the prospectuses could see that there were many critical differences between one triple-B bond and the next—the percentage of interest-only loans contained in their underlying pool of mortgages, for example. He set out to cherry-pick the absolute worst ones and was a bit worried that the investment banks would catch on to just how much he knew about specific mortgage bonds, and adjust their prices.

Once again they shocked and delighted him: Goldman Sachs e-mailed him a great long list of crappy mortgage bonds to choose from. “This was shocking to me, actually,” he says. “They were all priced according to the lowest rating from one of the big-three ratings agencies.” He could pick from the list without alerting them to the depth of his knowledge. It was as if you could buy flood insurance on the house in the valley for the same price as flood insurance on the house on the mountaintop.

The market made no sense, but that didn’t stop other Wall Street firms from jumping into it, in part because Mike Burry was pestering them.

Riaz Haq said...

Pakistan's CDS's rising again, according to Daily Times:

KARACHI: As uncertainty digs further in the Pakistan politics, country’s international sovereign yields and Credit Default Swap (CDS) are on the rise again, requiring higher premium for investments.

In Pakistan’s case, both the indicators have been again showing a persistently rising trend off late. Eurobond yield (maturity 2016) is currently edging 14.5 percent while CDS is already hovering around 1,000bps mark.

Both peaked out during Oct-Dec 2008 when Pakistan was near default (yield went as high as 26.2 percent while CDS as 5,105bps or 51 percent) while bottomed out in April 2010. This Eurobond+CDS based RRR however does not include currency risk premium (as sovereign bonds are mostly USD denominated).

Amongst other country risk premium measures, Eurobond yield-plus-CDS can be used to gauge foreign investor’s required rate of return (RRR) for a particular country.

Therefore, adding currency risk premium scales foreign investor’s RRR even higher thereby adjusting values of either stocks or fixed income securities downwards. It is quite evident in the current scenario that with country’s risk going up as reflected by rising Eurobond yield and default risk premium (even though liquidity of the two is very low, frequently causing wild changes in yields as well as default swaps), foreign outflows become more persistent.

Pakistan’s Eurobond yield, which incorporates sovereign investment risk, and CDS, which entails insurance of a country’s default on its foreign bonds, has been once again on the rise.

A quarterly basis probe over the last 4 years reveals that whenever foreign investor’s RRR goes higher than that of the local, it causes faster outflows than usual, underpinning increased volatility in capital markets. If we see the first RRR graph alongside, it shows whenever foreigner’s RRR was at premium to local’s (excluding currency risk premium) it caused severe outflows from country’s financial markets (second RRR graph).

On the other hand, when both the required returns collide (as in the case during 1Q, 2Q and 3Q of 2011, despite worsening macros and heightened political risk) there was relatively low foreign activity at the markets. It also gives birth to a thought whether these foreign flows are all real. But largely, such behaviour of the investor hits logic as foreign investor incorporates currency risk that jacks up overall required returns when there is greater volatility in the currency market (as in Pakistan’s case now).

The current foreign RRR is therefore on the rise again (24 percent based on Eurobond yield+CDS only) and so are foreign outflows, while local average RRR stands at 20 percent (10-yr PIB yield+market risk premium). Thus, foreign outflows will continue till both the RRRs collide once again, which is of course largely contingent upon overall political as well as macro economic risks in the country.\12\24\story_24-12-2011_pg5_1

Riaz Haq said...

Debt Markets worry over #Pakistan default on $50 billion debt coming due as Credit Default Swaps surge via @business

Bets are rising that Pakistan will default on its debt just as it starts to revive investor interest with a reduction in terrorist attacks.
Credit default swaps protecting the nation’s debt against non-payment for five years surged 56 basis points over the past week amid the global market sell-off, the steepest jump after Greece, Venezuela and Portugal among more than 50 sovereigns tracked by Bloomberg. About 42 percent of Pakistan’s outstanding debt is due to mature in 2016 -- roughly $50 billion, equivalent to the size of Slovenia’s economy.
Prime Minister Nawaz Sharif has worked to make Pakistan more investor-friendly since winning a $6.6 billion International Monetary Fund loan in 2013 to avert an external payments crisis. The economy is forecast to grow 4.5 percent, an eight-year high, as a crackdown on militant strongholds helps reduce deaths from terrorist attacks.
"Pakistan’s high level of public debt, with a large portion financed through short-term instruments, does make the sovereign’s ability to meet their financing needs more sensitive to market conditions," Mervyn Tang, lead analyst for Pakistan at Fitch Ratings Ltd., said by e-mail.

Since Sharif took the loan, Pakistan’s debt due by end-2016 has jumped about 79 percent. He’s also facing resistance in meeting IMF demands to privatize state-owned companies, leading to a strike this month at national carrier Pakistan International Airlines Corp.
The bulk of this year’s debt, some $30 billion, is due between July and September, and repayments will get tougher if borrowing costs rise more. The spread between Pakistan’s 10-year sovereign bond and similar-maturity U.S. Treasuries touched a one-year high on Thursday.
If Pakistan’s debt servicing costs rise, Sharif doesn’t have much room to maneuver. Already about 77 percent of the country’s 13 trillion rupees ($124 billion) budget for the year through June 30 is earmarked for interest and principal repayment on loans.


Another worry, as ever in Pakistan, is political stability. The military has ruled the country for most of the time since independence in 1947, and General Raheel Sharif -- no relation to the prime minister -- has boosted the army’s image with a campaign to root out terrorists who massacred 134 children in 2014.
While Raheel Sharif has said he plans to retire when his term ends in November, the risk of political upheaval is ever present. Pakistan has the 10th highest political risk score among more than 120 countries in the Economist Intelligence Unit ranking, worse than Egypt and Iran.