CDS contracts and the implosion of several Eastern European economies

Today I saw two blurbs about Eastern Europe which I want to pull together with a bit of added commentary about the automakers in the U.S.  The first blurb had to do with the Baltics and their probable downgrade to junk by the ratings agencies.  This is what Win Thin, a Senior Currency Strategist at Brown Brothers Harriman had to say earlier today in a market commentary.

Fitch cut the outlook for Bulgaria’s BBB- rating to negative from stable. The agency cut Bulgaria to BBB- from BBB back in Nov. Fitch cited the deterioration in the global outlook along with Bulgaria’s high current account gap (25% of GDP in 2008!) and large external financing needs as factors behind the outlook cut. IMF is now looking for 3.5% contraction in GDP this year and 1% in 2010, and also sees a big decline in net capital inflows, both portfolio investment and FDI shrinking noticeably. Our sovereign ratings model rates Bulgaria at BB vs. actual BBB/Baa3/BBB-, and believe that a junk rating is only a matter of months away. Bulgaria is not the only one in the region facing downward ratings pressure, and we continue to express amazement that so many were given investment grade ratings in the first place. Looking ahead, we see the three Baltic nations all moving into junk territory (only Latvia is junk right now). Bulgaria pegs the lev against the euro, and so far it has held up. However, if the Baltics continue to deteriorate, we cannot rule out broken pegs for all four (Estonia, Latvia, Lithuania, and Bulgaria). To us, Eastern Europe now looks very much like Asia did back in 1997, and we all know what happened then.

I hope this argument sounds familiar because it is something I have been saying since last Summer (I also mentioned similar comments from BBH earlier this month.

Fine. But, then I saw a Blurb from Gillian Tett of the FT. She is the same Gillian Tett who wrote “Saving The Sun” a look at a Japanese bank restructuring in the aftermath of the lost decade in Japan. In this case, she was looking at a bank in Kazakhstan (for your cycling and cinema enthusiasts, this is home to Alexandre Vinikourov and Borat).

Here’s what she says:

As the financial crisis virus has swept around the globe in recent months, Kazakhstan’s banking sector has been engulfed in turmoil. This is not just creating a headache for the Kazakh government and Western creditors, but also highlighting issues about the credit derivatives market that extend well beyond those far-flung steppes.

Take the case of Morgan Stanley’s dealings with BTA, Kazakhstan’s largest bank. A few years ago, BTA – like many of its Eastern brethren – was an up-and-coming darling of the capital markets world, with investment bankers furiously competing to float its bonds, provide loans, and much else.

But earlier this year, when funding dried up for Kazakh banks, BTA fell under the control of the government. Initially BTA wanted to keep servicing its loans, and its creditors, such as Morgan Stanley, appeared happy to play along.

But last week Morgan Stanley and another bank suddenly demanded repayment. BTA was unable to comply, and thus tipped into partial default. That sparked fury among some other creditors, and shocked some Kazakhs, who wondered why Morgan Stanley would have taken an action that seemed likely to create losses.

One clue to the US bank’s motives, though, can be seen on the official website of the International Swaps and Derivatives Association. One page reveals that just after calling in the loan, Morgan Stanley also asked ISDA to start formal proceedings to settle credit default swaps contracts written on BTA.

Does this sound familiar? No. Well, I did just mention earlier today that CDS contracts were going to be an impediment to a good workout at Chrysler and GM:

CDS insurance writers. Get ready for major pain. If bond holders are getting screwed, you know the companies who guaranteed credit default swaps (CDS) are not going to be very happy here. Question: are bond holders playing chicken because they have insurance? If so, you can consider the CDS writers another negotiating party that did not get a seat at the table and are going to be left holding the bag – a reason to want some major changes in how the CDS market is run.

Let me pull these threads together. If one thinks that a bankruptcy of a systemically important organization in any country can proceed normally without the potential for mischief, one had better read Tett’s account.

What’s more, in the case of Chrysler and GM, the complexity of a Chapter 11 bankruptcy will be very large. The Obama team says “three months and you’re done.” That ain’t gonna happen. United took three years. LTV took five and Delphi, the auto parts maker is still in bankruptcy 4 years later. So, lets get realistic here.

Bringing this full circle, we come back to Europe. And there, we have a problem, – specifically, because what has happened in Ukraine is going to happen in places like Bulgaria, Latvia, Lithuania or Estonia.

In my view, the events in the home of Borat and the possibilities in Eastern Europe or with the U.S. automakers present a good example why Warren Buffett calls derivatives financial weapons of mass destruction.

The credit default swap market needs regulation – and fast.

Insight: Kazakh bank falls foul of CDS – Gillian Tett,

  1. Steve says

    Great post – keep up the excellent work!

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