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Just because you have a CDS swap supposedly covering your investment doesn't mean that your counter-party will be able to pay if it is triggered.

Granted, but if you buy CDS protection it's because you expect to be paid in case it is triggered, right?

Right?

Um...

the whole point of CDS swaps was to enable you to treat risky junk as though they were AAA investments and relieve you of the obnoxious reserve requirements

Okay, let's parse this.

The following table applies for its risk-weighting:

Claims on sovereigns and their central banks will be risk weighted as follows:
Credit AssessmentAAA to AA-A+ to A-BBB+ to BBB-BB+ to B-Below B-Unrated
Risk Weight0%20%50%100%150%100%
A triple-A bank has a risk weighting of 20%.

Capital is 8% of risk-weighted assets.

So... take a Greek bond.

Before the crisis started, Greece was in the category where its bonds had a risk weighting of zero. So, holding a Greek bond costed no capital.

Now, Greece is rated below B, so its risk weighting is 150%, so the capital charge is 8% times 150% or 12% of notional.

You can buy a CDS at a 16% annual premium. The capital charge for the AAA CDS is 8% times 20% or 2%.

So, does it pay to free up 10% of notional from the capital charge, at the expense of 16% annually in CDS premia? I don't think so.

Economics is politics by other means

by Migeru (migeru at eurotrib dot com) on Wed Jun 15th, 2011 at 05:07:21 PM EST
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