Trading in sovereign credit default swaps has risen fivefold since the demise of Lehman Brothers last fall (see previous post on tradable CDS indexes, and current Financial Times article). This increase in trading, and general levels of increased government debt, have caused CDS spreads to rise and somewhat fall back to earth over the last year (see figure below).
Source: Markit (by way of the Financial Times)In the UK, the cost to protect sovereign debt soared to 164 basis points, compared to its pre-Lehman levels of 10bp last February (see Financial Times article). This means that at one point it costs $164,000 to insure $10m of UK debt, instead of the initial $10,000. Eventually, the cost fell back to 75bp as speculators began leaving the once volatile market. CDS spreads in Germany, the U.S., and Japan have seen similar rising and falling trends, although not as pronounced as the moves in the UK CDS market.
Even though the number of outstanding contracts are much less than many big companies, the moves are is still raising some concern, and highlight how investors now see "risk-free" government debt. And while it is also unlikely that sovereign CDS are being used for hedging in any direct, or large-scale way (after all, if there is a massive government default, good luck finding the counterparty), the markets do still provide information, even if the participants are not actually expecting large established governments to default.
So why waste a good financial product? Here is a suggestion (tongue in cheek - sort of). Given that governments around the globe are looking to rein in risk-taking by placing curbs on executive pay in companies that take on too much risk (see WSJ article), might it also be possible to do the same for governments that are spending too much and creating too much debt? In a rather ironic twist, maybe the sovereign CDS market could be used to place curbs on Congress? Now that is some market regulation that even Wall Street could get behind.
I LOVE this idea!