We’ve all read about Iceland, which is negotiating with Russia for a multi-billion dollar bailout loan. That begs the question: are other countries at risk of going bankrupt? Economists have drawn up a list of criteria that puts sovereign countries at risk. This includes countries with soaring inflation, high current account deficits, fast and aggressive expansion of consumer credit, easy credit that fuelled an unsustainable property boom, undercapitalized banks, overheated stock markets and exposures to short-term overseas borrowing coupled with large short term debt repayments. The situation in Ukraine unfortunately meets all the above criteria and conditions are getting worse. Ukraine is especially vulnerable since government revenues are so reliant on steel, chemical and commodity exports, prices for which are falling as the world heads into a recessionary period.
These vulnerabilities do not mean that a crisis/collapse will occur with certainty, but only that the probabilities are now substantially higher. Bankers from Citibank, J.P. Morgan and Standard and Poor’s are forecasting that there is a 80-90% probability that Ukraine will face a financial crisis by 2009. Ukraine and Hungary held emergency meetings with the IMF this past weekend to arrange for billion dollar bailout loans. Ukraine’s natural gas company Naftogaz, is on the verge of defaulting on a $500 million Eurobond.
Is there a way to predict if and when a banking sector or indeed a country might go bankrupt or in effect, default on its bond obligations to investors ? One predictive indicator is a financial instrument called a Credit Default Swap or CDS. A CDS is an insurance-like contract that promises to cover losses on a bond in the event of a default by the bond issuer, such as the government. The buyer of the CDS pays a premium over a period of time in return for the coverage of losses if a default should occur.
The CDS market is relatively new. Created in 1994, it is estimated at 60 trillion dollars today. The higher the premiums on CDS, the greater the risk of default. For 5-year bonds issued by emerging governments, currently the CDS premium is from 50 to 200 basis points/year. (One basis point is equal to .01 percent). A premium of more that 500 basis points is an indication that investors expect the bond to default.. For comparison sake, a few days before their collapses, CDS premiums hit 740 basis points for Bear Stearns and 724 basis points for Lehman Brothers. A recent CDS premium on Ukrainian government bonds skyrocketed to over 900 basis points this month, compared to 350 back in June 2008.
The creditworthiness of at least 20 countries around the world has more than halved in the last six months as the global credit crisis has deepened. There are growing fears that along with Ukraine, other countries such as Pakistan, Iceland, three Baltic states -Estonia, Lithuania, and Latvia, Hungary, Bulgaria, Romania, Serbia, Sweden, Greece, Italy, Turkey, Kazakhstan, Vietnam, South Korea, Venezuela, Mexico, Bolivia and Argentina could all slide into a downward spiral towards bankruptcy. Russia could join the list if crude oil prices fall below $70 a barrel and stay there. Credit-default swaps (CDS) on Gazprom, the Russian state-controlled monopoly for natural gas exports, climbed 79 basis points to a record 1,011 basis points. CDS on Russian government debt rose 125 basis points to 738 basis points , according to CMA Datavision The International Monetary Fund said it is mobilizing a fund worth several hundred billion dollars to stop a domino collapse across the developing world. Pakistan has the highest CDS premium at 25.72 percent, followed by Argentina (23.83 percent), Venezuela (16.51 percent), and Ukraine (16.20 percent). Iceland, whose government is rumoured to be on the verge of bankruptcy is trading at 25 percent. This is equivalent to a CDS price of about 1,500 basis points. Ukraine's gas company, Naftogaz is technically in default on its Euro bond, due in 2009, because it has not submitted audited accounts for 2007. Naftogaz' five-year credit default swaps, are trading at levels around 2,000 basis points, indicating a strong risk of default. That means it would cost $2 million a year to insure $10 million of five year debt. If Ukraine defaults, what could we expect? Ukraine’s liabilities must be paid by the CDS counterparty or counterparties. For more answers, we only have to look back to the Russian 1998 banking crisis, when Russia (which owned all the banks) was forced to admit insolvency. International investors fled, dumping Russian assets, which led to a run on the currency. Assets including real estate plummeted in price. Corruption was rampant. Wages to state employees went unpaid, causing widespread social and political unrest. The Russian stock market lost 75 per cent of its value. The IMF eventually stepped in with a $23bn financial package and the Russian government was forced to devalue the rouble. Eventually, calm was restored and global panic was averted, but, that was single country crisis. What if we get the unprecedented situation of 10 or more countries spiraling into bankruptcy all at once?
UPDATE: In December 2007, the Bank for International Settlements reported derivative trades tallying in at $681 trillion - ten times the gross domestic product of all the countries in the world combined. When all the smartest financial guys in the banking industry designed the concept of credit default swaps, they forgot to ask one question - when the system comes crashing down -what if the parties on the other side of the table don’t have the money to pay up the bet?
UPDATE: Friday Oct 24, 2008- S&P cuts Russia’s long-term credit rating to negative.
UPDATE: Sunday Oct 26th; CBS 60 Minutes featured a program on Credit Default Swaps see --A Look At Wall Street's Shadow Market