Credit Default Swaps (CDS) are one of those technical financial terms that are bandied around, apparently more often to confuse rather than to clarify. Here is a great example of where our industry goes out of its way often to create private expressions, keeping the knowledge of what they are up to within the coven and not for the broader masses. Heaven forbid that we should actually be using the same language as the rest of the population. Such practice is common in many professional areas where "technical expertise" is often a great excuse for using obscure terms and obfuscation – lawyers, please stand up.
The truth is that actually a CDS is just a form of insurance, but rather than being on a house or a car or even an individual (as in life assurance) it is on a specific financial instrument like a bond or a mortgage. A CDS reflects the annual cost of insuring against the default of the borrower: the higher the likelihood of default, the higher the CDS price. Now there is nothing wrong with insurance - in fact it is a vital part of the economic and financial structure of the capitalist world. However, like any product, if taken to an extreme it can have some rather strange and generally unwanted consequences.

An example of this would be the growth in trading in these insurance policies – CDS – such that they almost have a greater importance than the underlying asset that is being covered. Trading in CDS on, say, Italian government debt reflects the risk of default on the bonds. The more fearful markets get and they more they fear default, the more CDS or insurance will be bought - driving bond yields up to (theoretically) reflect the level of default that the CDS is implying. Higher bond yields are bad news for countries because they make the cost of borrowing higher which then increases the risk of default: the tail wagging the dog. Others are concerned about the complex web of counterparty relationships and obligations that has been built up with CDS trading: you can buy a CDS contract to be protected if the underlying borrower defaults, but someone else – usually an investment bank – has underwritten that CDS contract and has the obligation to pay you if the borrower defaults. But how credit-worthy is the bank that has underwritten the CDS contract? What other CDS have they underwritten? Can the CDS buyer really rely on them to pay out? These questions are complex and hard to answer and, in the event of a major default, these uncertainties could lead to paralysis in markets and banks mistrusting each other and refusing to trade.

So, instead of acting as a safety net, the Credit Default Swap market may in fact be increasing the risk and the potential collateral damage in the event of default.

Investors are completely justified in taking insurance on assets they own – insuring against default of the UK government because they have a large holding in UK Treasury bonds, perhaps. Companies and investors are also justified in taking insurance on other firms with strong links to their business – key suppliers or customers, whose demise would be detrimental to their own business. But what about betting on the failure of another firm, or the default of a government, for a speculative profit?

An example everyone can relate to is life insurance. We may take out a policy on ourselves in order to maintain family security. We may even take out insurance on a parent, perhaps to cover any inheritance liabilities. However no one sets up an open market trading on their mother's life. By having all sorts betting on her demise, you could end up with the illogical (not to mention undesirable) result that there are more people with an interest in ensuring her departure than preventing it! However, this is exactly the situation we are seeing in current CDS markets - we have created a mechanism which in some ways encourages betting on a default.

Instead of a guy rope of stabilisation, the CDS has become a lever of instability.

So what can be done? A system to allow insurance of your assets and investments is perfectly logical. A system allowing speculators to insure assets they do not actually own is patently not. In effect, it creates a sub-market trading in the insurance, which puts a greater, but less visible burden upon the underlying asset and creates far larger risk if it were to collapse. This would become an inverted house of cards all balanced on one single card at its base.

Call time on these unnecessary sub markets: CDS should be allowed but only for assets you actually own, or have some tangible connection with. They should not be used as a trading instrument for market punting.

Three years ago we had banks like Lehman’s, Bear Stearns and of course our own Northern Rock getting into trouble as a result of their dependence for funding on the short-term money markets. Once these seized up, this dependency became their fundamental flaw as they lost their ability to refinance by rolling over debt.

Three years on and we are in a similar position - this time not with banks but with Italy. She can’t print any more currency – not her decision – and needs to refinance significant debt, with €350billion coming due over the next year. The key issue here though is size – I am sure you will remember that Lehman’s bond debt was a mere $150bn, whereas Italy’s total debt is around $2,500bn. Gosh!

Maybe the eye-watering size of this will finally mean that we are going to see some movement, not to resolve the symptoms of bank and government debt, but to address the cause in the underlying operation and disciplines of the Euro currency itself.
One path of possible direction has been suggested by the “five wise men” (although only three will be needed next month) who advise the German government, presumably on their way to Bethlehem. They are suggesting a “debt redemption fund” which would fund any sovereign debt above 60% of GDP under some strict rules and conditions and potentially be the path for the introduction of a far closer fiscal and currency union - at least for the core of the nations involved.

Such a move wouldn’t immediately solve all the problems, but at least would demonstrate some leadership and hopefully restore some confidence. That alone could ease some of the fears over the spreads for Italy. However, every day that goes by in the current stasis of fear just erodes confidence, and such erosion weakens economies and growth. It’s like standing on the flanks of Vesuvius – you can feel the ground shaking and you know that something is going to blow, but nobody wants to believe it!

And finally... An exhausted Turkish man living in Germany has asked the police to protect him from his sex-mad missus, Bild reports.

The bleary-eyed victim of his wife's "voracious embraces" walked into a police station in the south western city of Waiblingen on Tuesday to explain he'd spent four years kipping on the sofa in a vain attempt to get some sleep. Police explained: "He has decided to get a divorce and to move out in the hope of finally getting some rest, particularly as he is anxious to arrive at work well rested. At the moment this is impossible because he says his wife keeps coming into the living room demanding that he perform his marital duties. He asked for police help in getting some sleep at night." Time to buy some headache pills I would suggest.

Have a good week.

Justin A. Urquhart Stewart

Director Seven Investment Management Limited