Suppose you own a BMW that costs $100k with five years left to drive. As per the rules, you have to buy insurance on the car, which ideally should cost a small percentage of the purchase cost. Then NTUC Insurance quoted $40k per year or $200k over five years. You look around and this seems to be the most "reasonable" price around. Over-the-top? Crazy?
Well, this is exactly the situation in the credit derivatives market for an emerging market name like Argentina or Pakistan. At 4000 basis points, one would have to shell out $400k of insurance (or more appropriately, premium) to cover $1M government debt issued by Argentina or Pakistan. Of course it is different from buying insurance for a beemer, because the market believes that the government is MORE LIKELY to default on payment than you wrapping the beemer around a tree.
Basic differences between an insurance contract and a CDS (credit default swap) contract:
- You don't need to own the underlying to buy a CDS i.e. I can buy protection (pay premium on a CDS contract) on a debt before owning the debt whereas you can't take out insurance on Mr Patel who owns the corner mama-store.
- You don't need to prove that you suffered a loss to "claim" the payout on a defaulted CDS ie if you buy a CDS on a Argentine bond and the government subsequently defaults, you will get a payout from the protection seller whether or not you bought the Argentina government bond. However if you "buang" a car and it miraculously escaped with no scratches or bumps, you won't get a single cent from the insurer.
Having said that, it's amazing how the market is pricing the default swaps now. Two years ago, a CDS on AA-rated Barclays PLC costs 10bp. Today it would cost 125bp for the same protection on AA-rated Barclays PLC. Simplistically it implied that the probability of default has increased 12.5 times. HSBC is a hefty 103bp while Singapore's very own DBS bank is at 180bp.
The all-powerful United States of America comes in at 30+bp. So what do you think of our beloved triple-A rated sunny island?
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