Watch the Indices! Derivatives and the Eurozone Sovereign Debt Crisis

by Anne-Laure Delatte, Julien Fouquau and Richard Portes, Voxeu.org

In retrospect, it is striking that the sovereign bond spreads of peripheral Eurozone countries surged while the economic conditions were gradually deteriorating. This column provides a new explanation for this phenomenon. It suggests that the markets in credit default swap indices have exacerbated shocks to economic fundamentals. The same change in fundamentals had a higher impact on the spread during the crisis period than it had previously.

The job of government bond analysts has been tough since the Eurozone crisis started. They’ve had to tell their clients a story behind every single bond spread hike since the fall of 2009. The list includes concerns over peripheral sovereigns’ public finances, deterioration of the fundamentals, financial sector credit risk, and European institutional coordination failures.

In retrospect, however, it is striking that aside from Greece, the sharp rise of peripheral sovereign bond spreads and their volatility is hard to reconcile with the underlying economic fundamentals. Spreads surged suddenly, while the economic conditions were deteriorating gradually.

• In Spain, for example, the public debt amounted to less than 60% of GDP even by end-2009.
• The Italian primary fiscal surplus implied that if interest rates had stayed low, only modest fiscal adjustment would have been necessary to service the debt.

Even invoking a broader set of news seems insufficient to explain the sudden eruption of the crisis. Unemployment and trade deficits had been increasing gradually. Weaknesses in the banking sector also appeared only gradually after the burst of property bubbles.

Non-fundamental factors

This suggests that some non-fundamental factor exacerbated shocks to economic fundamentals of peripheral European countries. That is, the same change in a fundamental may have had a higher impact on the spread in the crisis period than it had previously.

Previous research describes two different regimes, crisis and non-crisis, with additional fundamental factors important in the crisis regime (Aizenman et al. 2011, Gerlach et al. 2010, Montfort and Renne 2012, Favero and Missale 2011). These papers usually attribute nonlinearities to the fiscal situation. They find that yield spreads have become much more sensitive to fiscal imbalances after 2008, with a deterioration of fiscal indicators generating a significant widening of the spreads after 2008. But the crisis may have other than fiscal roots. Attributing amplification dynamics only to fiscal imbalances – an exogenous driver – is questionable in the light of recent advances in the study of financial market dynamics.

There is now extensive theoretical research stressing the importance of amplification dynamics in asset pricing, including sovereign debt markets. For example, the initial drop in asset prices will be exacerbated if it triggers fire-sale liquidations driven by the deterioration of the mark-to-market portfolio value. Relatively small shocks can imply large spillover effects (Brunnermeier and Pedersen 2009).

In our new paper (Delatte et al. 2014), we draw on recent research on financial crises to explore such dynamics in the sovereign bond markets of Eurozone peripheral countries. We explicitly test three hypotheses.

• First, the nexus between sovereigns and banks observed during the crisis (Gennaioli et al. 2010, Huizinga and Demirguc-Kunt 2010, Acharya and Steffen 2013) may have created a nonlinear relationship which goes both ways and features some amplification in the sovereign risk.
• Second, adverse liquidity effects on Eurozone banks have been documented during the crisis, including a significant fall of interbank loans after mid-2010 (Allen and Moessner 2013).

So, we examine the effects on sovereign risk of a negative externality due to fire-sale liquidation of assets by testing whether liquidity shocks have had self-reinforcing effects on sovereign bonds.

• Third, we explore the hypothesis that derivatives produce nonlinear systems (Brock et al. 2009) by investigating the effects on the sovereign price of credit default swaps (CDS), the most active credit derivative market.

Two co-authors of this paper have previously documented an adverse influence of the sovereign CDS on the underlying bond pricing when bearish investors use these instruments to express their views on the sovereign credit (Delatte et al. 2012 and Palladini and Portes 2011). But we know much less about the effects of financial sector CDS on the market’s evaluation of sovereign risk. In a down-cycle, their effect on the cash market may feed back to the sovereign risk. To explore this hypothesis, we focus on synthetic CDS indices which cover default risk on various pools of corporate entities because their standardization and liquidity make them the instrument chosen by investors to express views on market segments. We test whether a rise in CDS spreads amplifies the risk of sovereigns.

We estimate equations for the sovereign spreads of five European peripheral countries: Spain, Ireland, Italy, Portugal, and Greece over the period January 2006 to September 2012. We use a panel smooth transition regression technique, which allows us to locate when the transition to a new regime began and how fast it proceeded. Our estimates confirm the feedback loop from banks to sovereigns – the deterioration of financial names’ credit risk makes bond investors more risk-averse, so a shock to a fundamental is amplified when it is priced in the spread. This effect begins to operate in the autumn of 2010.

In addition, we uncover the channel through which the feedback operated, i.e. the price of two corporate CDS indices that cover financial names, i-Traxx Financials. Shocks to fundamentals are amplified when the price of financial CDS sub-indices increases. Figure 1, which plots the evolution of both financial CDS sub-indices, shows that their spreads fell from the 2009 peak to early 2010, then rose again up to autumn 2010 – the point at which the effect we identify begins to appear – and reach a second peak, significantly higher in 2012, when peripheral sovereign risk holdings of European banks put the entire Eurozone at risk.

Indeed, CDS are not only a measure of risk but also short positioning vehicles used by investors to express their views on credit. Market anecdotal evidence reports that from mid-2010, some traders have taken positions on the i-Traxx Financials to leverage their views on credit risk in the financial sector due to rising sovereign risk. As an example, ETF.com – a publication focused on financial indices – reports in June 2011:

“The two indices have been closely correlated – sovereigns have bailed out banks and banks are holding government debt.” (The i-Traxx SovX Western Europe includes the 15 most liquid sovereign CDS contracts.)

The up-front principal in buying CDS indices is small or zero. These instruments create high leverage. We conjecture that the large amplification effects detected by our estimates result from the high leverage on CDS indices and their late introduction into the market. In the context of the subprime crisis, Geanakoplos (2010) stresses that the late introduction of standardized CDS contracts into the mortgage market in 2005 precipitated its downturn, because the derivatives allowed the pessimists to leverage their credit views. Similarly, standardized CDS contracts on European corporate names were introduced in 2004 when the Europe i-Traxx index was launched. One consequence was that bearish investors had an opportunity to leverage after the market reached a peak, which magnified the depression of financial name prices in the context of the feedback loop between banks and sovereigns.

The International Monetary Fund has sought to rebut arguments that the sovereign CDS markets, in particular ‘naked’ CDS contracts, could be destabilizing (e.g. Global Financial Stability Report April 2010). Recently, the Fund took a broader look and concluded:

“The empirical results presented in this chapter do not support many of the negative perceptions about sovereign CDS” (Global Financial Stability Report April 2013, Ch 2).

We suggest they may have been looking in the wrong place and with inadequate tools. Theory exploring the dangerous bank-sovereign loop is supported by our results, in which financial CDS index derivatives appear to play a key role. Sovereign bond investors and regulators should monitor the credit derivative market carefully.

Figure 1: Financial i-Traxx Sub-indices

References

1. Acharya, V and S Steffen (2013), “The greatest carry trade ever? Understanding Eurozone bank risks”, CEPR Discussion Paper 9432.
2. Aizenman J, M M Hutchison, and Y Jinjarak (2011), “What is the risk of European sovereign debt default? Fiscal space, CDS spread, and market pricing of risk”, NBER Working Paper 17407.
3. Allen, W A and R Moessner (2013), “The liquidity consequences of the Eurozone sovereign debt crisis”, BIS Working Paper.
4. Brock, W A, C H Hommes, and F O O Wagner (2009), “More hedging instruments may destabilise markets”, Journal of Economic Dynamics and Control, 33: 1912–1928.
5. Delatte, A L, J Fouquau, and R Portes (2014), “Nonlinearities in sovereign bond pricing: the role of CDS indices”, CEPR Discussion Paper 9898, NBER Working Paper 19985, March.
6. Delatte, A L, M Gex, and A Lopez-Villavicencio (2012), “Has the CDS market influenced the borrowing cost of European countries during the sovereign crisis?”, Journal of International Money and Finance, 31(3).
7. Favero, C and A Missale (2012), “Sovereign Spreads in the euro Area. Which Prospects for a Eurobond?”, Economic Policy, 27(70): 231–273.
8. Geanakoplos, J (2010), “The leverage cycle”, NBER Macroeconomics Annual 2009, Volume 24, University of Chicago Press: 1–65.
9. Gennaioli, N, A Martin, and S Rossi (2010), “Sovereign default, domestic banks and financial institutions”, CEPR Discussion Paper 7955.
10. Gerlach, S, A Schulz, and G B Wolff (2010), “Banking and sovereign risk in the Eurozone”, Deutsche Bundesbank Discussion Paper 09/2010.
11. Huizinga, H and A Demirguc-Kunt (2010), “Are banks too big to fail or too big to save? International evidence from equity prices and CDS spreads”, European Banking Center Discussion Paper 2010-15.
12. Montfort, A and J P Renne, “Decomposing euro-area sovereign spreads: credit and liquidity risks”, forthcoming in the Review of Finance.
13. Palladini, G, and R Portes (2011), “Sovereign CDS and Bond Price Dynamics in the Eurozone”, CEPR Discussion Paper 8651.