Earlier this year, Deutsche Bank quietly decided to reduce its exposure to Italian government bonds. But it did not do that by simply selling debt; instead it achieved this partly by buying protection against sovereign default with credit derivatives contracts. That duly enabled the doughty German giant to report that its exposure to Italian sovereign bonds had dropped an impressive 88 per cent during the first half of the year – at least, when measured on a net basis – from €8bn to less than €1bn.
So far, so sensible; or so it might seem. But there is a crucial catch. These days, it is becoming less clear whether those sovereign CDS contracts really offer effective “insurance” against default. And that in turn raises a more unnerving question: if the exposures of the large European banks were measured in gross, not net, terms, just how much more vulnerable might they be to sovereign shocks? Or, to put it another way, could the problems now hanging over eurozone banks and bond markets be about to get worse, due to the state of the sovereign CDS sector?
The issue that has sparked this debate is, of course, Greece. In October, eurozone leaders announced that they intended to ask investors to swap any holdings of existing Greek sovereign bonds for new bonds, with a 50 per cent haircut. Logic might suggest that a loss that painful should count as a default. If so, logic would also imply that it merits a CDS pay-out.