Today www.reuters.com featured a story on the relationship between credit default swap spreads and default probabilities, a frequent topic on these blogs. Spreads represent the intersection of supply and demand for credit for that particular reference name. Spread-default probability relationships have changed dramatically over the 2007-2009 credit crisis, particularly for those firms where the senior debt holders have benefitted from government support. With permission, we reproduce the story by Karen Brettells of Thomson Reuters in full.
To see the story on www.reuters.com, please click on this link:
http://www.reuters.com/article/BANKSL/idUSN0647268620091006
Some banks' risk is higher than CDS implies-Kamakura
Tue Oct 6, 2009 1:08pm EDT
NEW YORK, Oct 6 (Reuters) - Improvement in credit default swaps on U.S. and European banks, including Citigroup, UBS and Allied Irish Banks, may not fully capture the risks that investors could take new losses to the firms, according to data by risk management firm Kamakura Corp.
Credit default swap prices on banks have rallied as government support programs help shore up bank capital levels and improving economic conditions enhance their earnings outlook.
For most banks, the risk of default implied by swaps, based on their senior unsecured debt, has dropped to negligible levels. Credit default swaps are used to insure against a borrower defaulting on their debt, or speculate on their credit quality.
For some firms, however, the risks of further losses to bank securities in the short term may be higher than implied by the contracts, according to Kamakura.
Kamakura's default probabilities are designed to capture the risks of a failure, which could include regulatory capture or equity holders being wiped out.
CDS prices, which are closely watched as an indicator of corporate health, are primarily affected by the potential losses to be incurred by senior debt holders. Bank debt has been largely shielded from government interventions.
Swaps are also swayed by market factors including liquidity and risk aversion.
"CDS are not based on observables, but are a function of momentum," said Christopher Whalen, managing director at Institutional Risk Analytics.
A comparison of defaults implied by CDS levels with that of Kamakura, which produces default probability ratings for around 27,000 firms, shows that some of the largest diversions between the two default probabilities are on the riskiest large banks.
These include Banco Santander (SAN.MC), Allied Irish Banks (ALBK.I), Bank of Ireland (BKIR.I), UBS (UBSN.VX) and Citigroup (C.N).
Allied Irish Banks and Bank of Ireland are seen as being among the riskiest banks in the short-term, with default probabilities of 12.98 percent and 10.52 percent over the coming year, respectively, Kamakura data shows.
This compares with implied default risk of 1.6 percent and 1.65 percent, based on their CDS prices.
Ireland is suffering from the bursting of a property bubble which revealed that its major banks were heavily overextended and at risk of nationalization.
Banco Santander is also seen as having a 9.43 percent default probability over the coming year, according to the Kamakura's data, while the bank's CDS attributes only a 0.44 percent default risk in the same period.
UBS also poses an 8.09 percent risk of default over the coming year, based on Kamakura data, as compared with an implied risk of 0.69 percent in the bank's CDS. Citigroup, meanwhile, has a default probability of 3.54 percent over the coming year from Kamakura, compared to a CDS implied default rate of 1.62 percent.
The low default probability of default present in banks' CDS spreads bucks a larger trend, in which CDS spreads overstate the credit risk of a firm, relative to Kamakura's analysis.
Defaults implied by CDSs can overstate actual failures as sellers of protection will typically require a premium for taking on the risk, especially when a company becomes distressed.
Ambac Financial Group (ABK.N), YRC Worldwide (YRCW.O) and iStar Financial (SFI.N), are among companies that have a significantly higher default probability implied by their CDS spreads, compared to Kamakura.
For example, CDSs on Ambac's bond insurance arm, Ambac Assurance Corp, are implying an 87.6 percent chance of a failure over the coming year. This compares to Kamakura's default probability of 8.71 percent for the same time frame, which is down from a peak of more than 65 percent in March.
To compare CDS and Kamakura default probabilities on Thomson Reuters, go to: (link requires a subscription to Reuters 3000Xtra)
(Reporting by Karen Brettell)