Greece and Dubai show system remains unstable

By Gillian Tett
Published: November 26 2009 20:35 Last updated: November 26 2009 20:47

A watershed in the derivatives world could be reached this week: the cost of insuring against a bond default by Greece, using credit derivatives, may rise above the comparable metric for Turkey for the first time.
Just two short years ago, that would have seemed almost inconceivable to most credit default swaps traders, never mind proud Greek politicians. After all, in 2007, the Turkish CDS spread – like that of many “emerging markets” – was trading at about 500 basis points on perceived fiscal risks.
Greece, by contrast, was nearer 15bp, because it was a member of the European Monetary Union, and its euro-denominated bonds were considered quasi-protected by other euro states.
But in the past year the fiscal positions of many emerging markets nations, such as Turkey, have become more favourable relative to the western world. Meanwhile, Greece has plunged into a profound budgetary mess, notwithstanding its use of the euro.
Thus on Thursday – as markets reeled from the Dubai shock and investors fled from risk – the bid-offer spread on five-year Greek CDSs was 201bp-208bp, according to Markit. That of Turkish CDSs was 207bp-212bp, leaving them neck and neck (and according to Bloomberg data, in some trades the Greek CDS was even higher than Turkey).
All this is a bitter blow to Greek pride. However, there is a much bigger moral here, which cuts to the heart of the Dubai saga, too.
Two years ago, global investors generally did not spend much time worrying about so-called “tail risk” (a banking term for the chance that seemingly remote, nasty events might occur). After all, before 2007, when the world was supposedly enjoying the era of the “Great Moderation”, the world seemed so stable and predictable that it was hard to imagine truly unpleasant events occurring.
But in the past two years, a seemingly safe financial system has crumbled, and – to paraphrase Lewis Carroll – investors have repeatedly been asked to believe six impossible things before breakfast, ranging from the collapse of Lehman Brothers to the implosion of Iceland (and much else). Tail risk, in other words, has leapt into investor consciousness.
And while the financial markets have stabilised in the past six months, that lesson about tail risk cannot be easily unlearnt. The sheer psychological shock of 2007 and 2008, in other words, has left investors looking like veterans from a brutal war. Long after the fighting has stopped, the mere sound of a “bang”, is apt to leave them running for cover.
All this does not mean – let me stress – that it is correct to expect the world to melt down imminently. The fact that the CDS spread for Greek bonds has swung from 5bp to 200bp, in other words, should not be interpreted as a sign of an imminent Greek default, or a likely break-up of the euro. The CDS market is pretty illiquid and prices can swing on low volumes.
But what the CDS market does capture is the perception of tail risk, or low-probability outcomes. Or, to put it another way, the market projects what could occur if the current fiscal and political situations were taken to logical extremes.
Much of the time investors are tempted to ignore those logical extremes. After all, they have known for months that Dubai World was dangerously over-leveraged. They assumed that this would not be too dangerous, because they thought that foreign investors would always be protected.
Now, however, that assumption has been challenged. Tail risk has resurfaced with a vengeance. Little wonder that the CDS spreads of some other debt-laden emerging markets, such as Hungary, swung wider, too, on Thursday. Nor that the Greek CDS moved as well.
For while investors used to assume that it was just emerging market countries that were prone to suffering truly nasty fiscal shocks, the debt fundamentals in Dubai are not necessarily so different from those in developed nations, be that Greece or even the US. Suddenly the line between “emerging” and “developed” countries is becoming more blurred.
So perhaps the best way to view the events in Dubai – and the Greek CDS price – is as a welcome wake-up call. In recent months, a sense of stabilisation has returned to the financial system as a whole, as central banks have poured in vast quantities of support. A striking liquidity-fuelled asset price rally has also got under way.
But the grim truth is that many of the fundamental imbalances that created the crisis in the first place – such as excess leverage – have not yet disappeared. Beneath any aura of stability huge potential vulnerabilities remain. If Thursday’s events prompt investors to remember that, so much the better; not just in Dubai but in Greece, too.