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?
