Credit - Gunfight at the O.K. Corralito

"Peace cannot be kept by force; it can only be achieved by understanding." - Albert Einstein 

Looking at the evolution in Cyprus, reminiscent of Argentina's 2001 "Corralito", which eventually led to its default, we thought this week it would be entertaining to use in our title, yet other multi-dimensional references as per last week conversation "The Doubt in the Shadow". 

Our first reference is of course the "Gunfight at the O.K. Corral" which took place on the 26th of October 1881 in Tombstone Arizona, and is generally regarded as the most famous gunfight in the history of the American Old West. Arguably our European Gunfight at the O.K. Corralito, will no doubt be regarded as the most infamous "deposit-levy" fight in "Old Europe's history". The O.K. Corral gunfight represented a time in American history where the frontier was open range for outlaws (tax havens) opposed by law enforcement that was spread thin over vast territories (Europe), leaving some areas unprotected (Cyprus). In similar fashion, the lack of a true European Banking Union from inception of the European project, means, that given the European banking sector's  leverage and thin equity buffers, the depositors can rightly feel unprotected. Yes, we know, on the 29th of June 2012, European leaders expressed their determination to "break the vicious circle between banks and sovereigns". The initial statement focused on the establishment of a "Single Supervisory Mechanism" (SSM) which would pave the way to direct recapitalization of banks by the ESM (European Stability Mechanism). This banking union would not just cover the Eurozone initially but would also be open to the soon to be 28 members of the EU (with Croatia being the next joiner), if they choose to join.

Our second reference is of course, Argentina's 2001 Corralito, which has been recently reenacted in October 2012, limiting ATM withdrawals for Argentinians. The Corralito was the informal name taken by Minister of Economy Domingo Cavallo's economic measures in order to stop bank runs in Argentina. It was not very successful...

Our third reference, is less so evident, but nonetheless, entertaining we think, given the famous Gunfight at O.K. Corral, also gave its name to a mathematical model - The Ok Corral and the Power of the Law (A Curious Poisson-Kernel Formula for a Parabolic Equation) by David Williams and Paul Mcilroy submitted in 1998:

"Two lines of gunmen face each other, there being initially m on one side,n on the other. Each person involved is a hopeless shot, but keeps firing at the enemy until either he himself is killed or there is no one left on the other side. Let μ(m, n) be the expected number of survivors. Clearly, we have boundary conditions:

We also have the equationThis is because the probability that the first successful shot is made by the side with m gunmen is m/(m + n). On using the recurrence relation (1.2) together with the boundary condition (1.1), the computer produces Table 1 below, in which1991 Mathematics Subject Classification 60F05."

In similar fashion each European politician involved in our European Gunfight at the O.K. Corralito is as well a "hopeless shot" but keeps firing (or making blunders that is) until either he himself is killed (or his country's economy) or there is no one left on the other side (we have yet to see an Italian government...). Of course there is an elegant solution to this mathematical model - Solution to the OK Corral model via decoupling of Friedman's urn by J.F.C. Kingman and S.E. Volkov. Just for an illustration, the authors presented the probability that exactly 5 gunmen would survive provided there were initially 20 on both sides. 

We will let you mathematically work out in your own time how many  "hopeless shot European gunmen" will survive this "European O.K. Corralito gunfight" given than they will soon be 28 countries in the European Union, 14 on each side, but, as usual, we ramble again...

While in the last two credit posts we focused our attention on the lack of equity buffers (Dumb Buffers and The Doubt in the Shadow), in this week's conversation we would like to direct our attention to the "unintended consequences" of the Gunfight at the O.K. Corralito given that, in true "Zemblanity" fashion. (Zemblanity being defined as "The inexorable discovery of what we don't want to know"), there will indeed be casualties, and most likely in the peripheral banking space that is, with rising nonperforming loans due to lack of economic growth, thin equity buffers and high loan-to-deposit ratios and soon to happen deposit flights.

Although the intentions of the European Union has been to severe the link between financials and sovereigns with a move towards a European Banking Union, the ban on naked Sovereign CDS imposed on the 1st of November has effectively killed the Itraxx SOVx 5 year index market for good. This market had been trading closely to Itraxx Financial Senior 5 year index in the past (25 European banks and insurance single names CDS). Financial spreads have been as of late on the receiving end of the widening move in cash and CDS markets courtesy of discussions surroundings "bail-in" procedures  from one of the European gunmen (Jeroen Dijsselbloem). 

The EU Recovery and Resolution Directive proposes an orderly introduction of bondholder write-downs, with the bail-in tool set for implementation in 2018 but it looks like our lone gunman is trigger happy and ready to shoot early in the gunfight . Graph below SOVx versus Itraxx Financial Senior 5 year index since March 2011 -  source Bloomberg:

"27 February 2013 - The Markit iTraxx SovX Western Europe index will not roll into Series 9 in March 2013 due to low trading activity as recorded by the DTCC Section IV: Market Risk Transaction Activity data. Series 8 will remain on-the-run." - source Itraxx Markit

While Cyprus replaced Greece has a member of the SOVx index back in 2012, the only remaining series, will remain at 14 for the foreseeable future for lack of liquidity, or lack of market thereof:

Goodbye SOVx CDS market...

Financials have no doubt been the early casualties of the European Gunfight at O.K. Corralito, when one looks at the increasing divergence between the Itraxx Main Europe 5 year CDS (risk gauge for non-financial Investment Grade European Credit)  versus the Itraxx Financials 5 year CDS index - source Bloomberg:

In fact, CDS insuring against default on European financials have risen for 10 days in a row, the longest streak since August 2011, closing on the 28th of March towards the 205 bps, heading for its worst month since November 2011.

Of course in the financials space CDS wise, the Itraxx Financial Subordinated index (indicative of the risk gauge for subordinated debt, in the direct line of fire for bank recapitalization as per the SNS case...) took a pounding as well in this European Gunfight and widening towards 325 bps versus 205 bps for the Itraxx Financial Senior 5 year CDS index. - source Bloomberg:

Back in February in our conversation "House of pain and House of cards" we argued  the following in relation to the SNS case which saw subordinated debt totally wiped-out by the Dutch government:

"If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS."

We were glad to see Matt King from CITI joining our concerns in his note on the 15th of March entitled "Behold the new form of bail-in":

"The CDS trade has the additional advantage that not only are losses at senior level becoming more likely, but sub CDS protection is likely to be rendered worthless in cases where bonds are completely converted to equity or wiped out, because of a lack of deliverables. With sub/senior relationships still trading pretty much in line with their long-term averages, this does not seem yet to be priced in (chart below).

Perhaps the SNS auction next week (which is likely to confirm sub recoveries of zero) will be sufficient to give trading a jolt, a result which seems quite likely if there are eventually auctions on Laiki Bank or Bank of Cyprus CDS.5 Conceivably it may take longer: as with many factors in the current outlook, we fear the potential for discontinuities even as the market fails to react today — a sort of “ball in a bowl” phenomenon.6 But even if it takes a while, we think the bailin of bank bondholders on one small island today is ultimately likely to have significance far greater than its size suggests." - source CITI

The recent  "Dutch" case of SNS Reaal has indeed illustrated the shortcomings of the restructuring credit events in financial CDS.  Given the Dutch government expropriated all of the lender's subordinated debt in February before a CDS auction could be held, we wonder if the Subordinated market will indeed suffer a similar fate to the Sovereign CDS market and SOVx in particular. CDS notionals have remained on a downward trend since the market's peak of USD 58trn notional outstanding at the end of 2007, touching a new low of USD 27 trillion at the end on June 2012, according to the Bank for International Settlements. A dying market or simply yet another victim of our European Gunfight at the O.K. Corralito. We wonder...

Another "unintended consequence of the European Gunfight, has no doubt been the growing divergence between European volatility gauge V2X and its US equivalent VIX - source Bloomberg:

 The spread between both volatility risk gauges has been rising steadily since December, closing towards 8.60 but has yet reached its 2011 record of nearly 15.

Of course the obvious "unintended consequences" of the Gunfight at the O.K. Corralito, should be that depositors will think about spreading their wealth across banks to ensure they are below the 100,000 euros "implicit guaranteed" threshold - Euro deposits table, source Bloomberg:

"A key positive of the restructured solution for Cyprus is the underpinning of the 100,000 euro deposit insurance scheme, explicitly noted in the release. A consequence of the decision to use uninsured deposits along with equity and bond instruments to part-fund the recapitalization of Bank of Cyprus may be depositors spreading money across banks to ensure they don't exceed the threshold at any one lender." - source Bloomberg.

And, as we posited in "Winner-take-all", should a deposit flight occur in Europe, depositors will no doubt seek a German bank sanctuary.

In this European Gunfight at the O.K. Corralito, we wonder if Germany is really a "straight-shooter" when looking at the level of capitalization of some of its banks which have been deeply impacted by their venture into structured finance and shipping in particular fuelled by cheap credit.

We discussed in depth the issues plaguing Germany's second largest bank Commerzbank in our conversation Dumb Buffers: "Not only have overbuilding occurred due to cheap credit that fuelled an epic bubble in the Baltic Dry Index, but, the on-going decline on vessel prices, will no doubt exert additional pressure on recovery values for Commerzbank's loan book".

Another high profile German institution which had been on the receiving end of state aid has been HSH Nordbank:
"In December 2008 HSH was granted to issue up to EUR 30bn guaranteed notes under the German SoFFin program. One requirement that was imposed on HSH was to raise the capital ratio to at least 8%. On January 20, 2009 EUR 3bn 3 year guaranteed notes were issued. On February 24, 2009 HSH received new capital of EUR 3bn and credit guarantees of EUR 10bn by the two main shareholders, the states of Hamburg and Schleswig-Holstein. The other shareholders, JC Flowers and the savings bank association, did not participate in the capital infusion. Together with this increase of its core-capital, HSH announced further restructuring. It plans to spin off non-strategic activities and the Toxic asset portfolio into a—yet to be created—Bad Bank." - source Wikipedia

Could HSH subordinated bondholders suffer the same fate as Dutch bank SNS? Of course!
We agree with a recent note from Bank of America Merrill Lynch on this subject entitled "At the mercy of shipping":
"The most recent legislative proposals in the German banking sector do not appear to allow for direct bondholder expropriation by the German government / states, as happened with SNS REAAL. But if HSHN’s key sector exposure (ie, shipping) does not show signs of stabilization in the near term, negative outcomes for bondholders (ie, (very) low recoveries) could be achieved through transfer orders and/or recovery / resolution plans, we think. Also, when considering the relentless drive by the EU towards bailing in sub bondholders, we would not necessarily take the existing regulatory framework and – proposals in Germany as the last word on burden sharing by sub bondholders." - source Bank of America Merrill Lynch.

For, us, you probably know by now, why shipping is a leading credit indicator. For Dutch SNS it was commercial real estate, for HSH (and Commerzbank as well) it is shipping issues first:
"Shipping – plagued by overcapacity
At end-1H12, HSHN’s exposure to shipping was EUR32bn, of which about EUR12bn was housed in the restructuring unit. The bank finances ship owners, not ship yards. Due to the overcapacity in shipping and the low level of fleet utilisation (exacerbated by weaker economic growth and reduced global trade flows), the sector has been struggling for some time now, which has led to higher problem loans for most lenders in this field. Collateral values (ie, ship prices) have also come down.
Overcapacity in the shipping industry is unlikely to be resolved until 2014 at the earliest, due to the high number of new ships ordered over the past few years. A number of competitors are retrenching from shipping finance. On the one hand, this could result in financing problems for some shipping companies. On the other hand, it could improve the competitive position of the remaining players. As for HSHN, it has agreed with the EC to reduce its shipping exposure to about EUR15bn by end-2014 and to limit its share of new business in worldwide ship financing to 5% until end-2014." - source Bank of America Merrill Lynch

As far as HSH credit metrics are concerned, they are indeed very weak as indicated by Bank of America Merrill Lynch in their note:

"HSHN’s asset quality is weak. At end-1H12, its reported NPL ratio was 12.6% and this is expected to have increased significantly in 2H12. The bank’s reliance on wholesale funding remains high, with a loan/deposit ratio of 195% at end-3Q12. Its profitability has been very poor in recent years - it was loss-making in 2008, 2009 and 2011. It expects to be loss-making again in FY12 and in FY13. The bank will report FY12 results on 11 April." - source Bank of America Merrill Lynch.

And given structured finance and shipping loan books are very dependent on the evolution of the US Dollar, we expect trouble ahead in accordance with Bank of America Merrill Lynch's note:
"However, in 1H12, the bank’s RWAs jumped by 32%. This was due to ‘the renewed appreciation of the USD […] as well as the crisis in the shipping markets, which caused the risk parameters to deteriorate significantly.’ The negative impact of this RWA increase on the bank’s capital ratios was mitigated by:
- the EUR500mn capital injection by the federal states of Hamburg and Schleswig-Holstein in January 2012 (see below); and 
- the est. EUR260mn gain on the cash tender offer for LT2 bonds in February
2012.

But this was insufficient to offset the decrease in the bank’s capital ratios caused by the negative rating migration and USD appreciation in the shipping portfolio. This has meant that HSHN now needs the additional capital relief of lower RWAs. Therefore, in February 2013 the bank asked the two states to return the asset guarantee to its original size of EUR10bn." - source Bank of America Merrill Lynch.

So yes, we think, that looking at the shipping industry HSH subordinated bondholders could indeed face the SNS treatment at some point...and we also think that German banks will most likely welcome deposits from stricken peripheral countries. Michelle Wiese Bockmann in her Bloomberg on the 1st of March entitled - German Banks With Record Soured Ship Loans Forgo Seizing Vessels:

"Deutsche Bank AG and two other German lenders providing about 14 percent of credit to ship owners are forgoing seizing vessels even after soured loans to the industry rose to a record.
Europe’s biggest bank by assets, as well as HSH Nordbank AG, the largest in the market, and Norddeutsche Landesbank Girozentrale, which finances 1,500 ships, are restructuring loans and setting money aside instead of repossessing vessels, officials from the companies said. They have about $69 billion in loans to the industry out of $500 billion in total, according to data compiled by the banks and Petrofin Research SA, an Athens-based consultant" - source Bloomberg

It looks to us that the German gunslinger, is no doubt, a "fast-draw" artist in this European Gunfight at the O.K. Corralito.
Oh well...

The other "unintended consequences" for large depositors could as well benefit the buy-side, with large depositors seeking potentially the havens of managed funds rather than concentrating their deposits in banks as indicated in another note from Bank of America Merrill Lynch:

"Yet large depositors have clearly been put on notice that they should be careful where they invest. In our view, this could push larger sums out of the banking system into managed funds, e.g. money market funds or fixed income funds, and will likely spread deposits across a country’s banking sector at the insured level (which may be positive for risk assets)." - source Bank of America Merrill Lynch - A backward step - 26th of March 2013.

One thing for sure, in similar fashion to the O.K. Corral gunfight, this European O.K. Corralito, will not end up nicely for some in particular and for the euro in general.

On a final note, we were entertained by Bank of England's announcement that UK banks had a capital shortfall of 25 billion pounds (38 billion USD), to cover higher estimates for loan losses due to their exposure to commercial real estate as reported by Ben Moshinsky in Bloomberg in his article - BOE Says U.K. Banks Have Capital Shortfall of $38 Billion:

"The BOE said expected losses on loans could exceed provisions by 30 billion pounds, while future conduct costs could be 10 billion more than banks expect. It said lenders underestimated assets weighted for risk by 170 billion pounds, leading to a 12 billion-pound capital shortfall in that category. While the full impact of the three areas could deplete lenders’ capital by 52 billion pounds, some banks already have enough resources to cover them, leading to a total 25 billion-pound shortfall." - source Bloomberg.

"The Bank of England warned expected losses from high-risk loan portfolios, including U.K. commercial real estate and euro zone exposure, could exceed existing provisions at major banks by about 30 billion pounds ($45 billion) in the next three years. Lloyds noted at FY12 earnings that U.K. commercial real estate values fell in 2012, and were down 4.2% yoy, with non-London asset values struggling and only 5% higher than their 2009 trough." - source Bloomberg.

What was our previous comment in our last conversation "The Doubt in the Shadow" on Chancellor of the Exchequer George Osborne's latest 130 billion pound worth of mortgages guarantees?
"This is pure madness and will end up in tears"

"Insanity - a perfectly rational adjustment to an insane world."- R. D. Laing, Scottish psychologist.

Stay tuned!

Credit - Promissory Hope

"The man who promises everything is sure to fulfil nothing, and everyone who promises too much is in danger of using evil means in order to carry out his promises, and is already on the road to perdition." - Carl Jung

"A promissory note is a negotiable instrument, wherein one party (the maker or issuer) makes an unconditional promise in writing to pay a determinate sum of money to the other (the payee), either at a fixed or determinable future time or on demand of the payee, under specific terms." - source Wikipedia 

Promissory notes differ from IOUs in that they contain a specific promise to pay, rather than simply acknowledging that a debt exists.

While looking at the political success of Ireland in obtaining finally some debt-relief, which could be seen as an interesting step for European politicians in helping struggling European countries, we thought our chosen title should be "Promissory Hope" given S&P has just raised Ireland's outlook from negative to stable, in the footsteps of rating agency Fitch's revised outlook on the 14th of November. Our title also reflects that while the ECB agreement brings some relief, it doesn't reduce in no way the stock of debt and the impact on the Irish budget deficit will be limited to 0.6% in 2014 and 2015.

No doubt the liquidation of IBRC (the remnants of former Anglo Irish Bank and Irish Nationwide Building Society has put to rest the burden of 3.1 billion euros of annual repayments for the next 10 years.

But, our chosen title is also directed towards the negative spread reaction in subordinated CDS and Lower Tier 2 cash bonds (used as reference obligation in the CDS space) since the announcement of the SNS nationalization and expropriation. We discussed this touchy subject in our previous conversation "House of pain and House of cards":
"The SNS case this week has had some major significant risks to the "House of pain" in the European banking sector that warrants additional close attention for the remaining subordinated bondholders.
If the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS. On top of that, a nationalization, such as SNS case, is not by itself a credit event trigger. Appointing an insolvency official is.
As far as delivery of LT2 underlying subordinated bonds referenced in any CDS contract referencing SNS, you would have to ask the Dutch state for delivery (if the subordinated bonds are not simply cancelled or converted into equity...).
So what's the value of your subordinated single name CDS on SNS? Could it mean single name subordinated CDS are a "House of cards"? We wonder. Oh well..."

Therefore in this conversation, we will focus on the implication for the Credit markets in general and the CDS market in particular.

While subordinated bondholders met their makers in the case of the nationalization process of SNS, at least Senior Unsecured bondholders got some welcome respite as indicated in the below Bloomberg graph on a specific SNS bond:

But given Germany, the Netherlands and Finland are looking at speeding up the European plans as soon as 2015 rather than 2018, to force losses on senior unsecured bondholders of failing European financial institutions, the bail-in push to protect European taxpayers looks to us that, rather that financial unsecured bonds are now more akin to "Promissory Notes" (or hope) rather than plain IOUs.

As indicated by Jim Brunsden and Rebecca Christie in their Bloomberg article from the 4th of February entitled "German Push to Accelerate Bank Bail-Ins Joined by Dutch, Finns":
"Senior bank bondholders so far have mostly avoided losses, while European governments and the International Monetary Fund have committed to 486 billion euros of aid since 2010. Under the EU plans, drawn up by the European Commission, regulators would be given the power to impose losses on holders of senior unsecured debt, as well as derivatives counterparties, once a lender’s capital and subordinated debt are wiped out. Regulators could also force debt to convert into common shares, so shoring up a struggling bank’s equity. 
Once the new rules take effect, national authorities would be expected to exhaust bail-in options before resorting to public money to stabilize the bank. 
 The nations are seeking a date as soon as 2015 because it would provide time to adjust to the measures while not putting individual countries at a competitive disadvantage if they apply bail-in rules ahead of 2018, one of the officials said."

Arguably this is what we have discussing in various conversations and is even more likely to happen sooner rather than later, we think as we posited in"Subordinated debt - Love me tender?" and "Goodwill Hunting Redux"):

"First bond tenders, then we will probably see debt to equity swaps for weaker peripheral banks with no access to term funding, leading to significant losses for subordinate bondholders as well as dilution for shareholders in the process." - Macronomics - 20th of November 2011.

As usual the credit markets are only waking up to the rising risk and acceleration of what pains could be inflicted higher up in the capital structure. On that specific subject, we would have to agree with CreditSights note from the 10th of February entitled "Exploring the Sub-Conscious":
"The market is much more used to the idea of "burden-sharing" in hybrid debt, be it through non-calls, coupon deferrals, discounted tenders or principal write-downs. Even so, most of the latest crop of announcements does not help sentiment across the subordinated asset classes." - source CreditSights.

In similar fashion that the Greek CDS saga, followed up by the ban on naked Sovereign CDS last year questioned the existence of the Sovereign CDS market, the SNS episode is no doubt, raising serious questions on the value of subordinated protection as we argued in our previous credit conversation.

On this specific subject, CITI's note from the 11th of February entitled "What bail-in means for CDS" poses some serious questions:
"CDS protection in question – The consequences for CDS may be at least as far reaching as for bonds. Even if expropriation is deemed to be a trigger event, there is a real risk that no subordinated bonds will be left outstanding to be delivered into the contract. This would render subordinated protection practically worthless in the particular case of SNS (given that senior bonds are trading close to par)." - source CITI

In similar fashion to the sovereign CDS markets, it could no doubt, inflict some serious liquidity constraints to the credit markets as well as much needed reality check as per CITI's note:
"If any bank bondholders had not previously noticed that the rules were being rewritten on them, then the 80-point drop in SNS subordinated debt ought to have served as a wake-up call. Yet to our minds the implications for CDS may be almost as dramatic, and yet ironically may cause the market to rally rather than to sell off. 
Broadly speaking, the problem is that CDS contracts were designed prior to the invention of bail-in. Unless lawmakers are careful, they risk situations in which CDS protection turns out to be worth much less than protection buyers would have hoped and expected, either because it is not triggered at all, or because of problems with a lack of deliverable obligations. This would not only be very damaging for the CDS market; it would have very negative consequences for bank bond liquidity too." - source CITI

The Greek PSI in conjunction to the naked ban on naked Sovereign CDS have indeed somewhat "killed" the trading in the Itraxx Sovereign index SOVX as indicated by CITI:

We have as well to agree with CITI that, increased likelihood of bail-in is probably negative for cash bonds but how negative?

EDHEC-Risk Institute in their January 2012 note entitled "The Link between Eurozone Sovereign Debt and CDS Prices" provides us with some insight on the aforementioned impact:
"To examine the difference between these spread measures, we priced a 5-year bond with a 5% coupon in an environment where the default-free yield curve is assumed flat at 3% and the Libor risk-free curve is also assumed to be flat at 3.5%. We considered two cases - first an expected recovery rate of 40% and second an expected recovery of 0%. We then varied the 5-year survival probability assuming a flat term structure of default rates11 and calculated the implied bond price and spread measures. In all cases we assumed k = 1.

Figure 2 Comparison of the model-implied CDS, bond yield-spread and par asset swap spread measures as a function of 

the full price of a 5-year bond with a 6% coupon. We show this for an expected recovery of 40% (above) and 0% (below).":

"The results are presented in Figure 2. When the expected recovery rate is 40% we find that as the 

bond price falls (and it cannot fall below 40), the CDS spread grows and asymptotically tends to infinity while the yield-spread and asset swap spread tend to different large but finite numbers. However, if we set the expected recovery rate to zero then the yield-spread also tends to infinity and is very close in value to the CDS spread as the bond price falls to zero." - source EDHEC-Risk

Therefore, as we indicated in our previous conversation, if the recovery rate for SNS LT2 subordinated bonds is zero, the significance for the European subordinated CDS market is not neutral to say the least given the assumed recovery rate factored in to calculate the value of the CDS spread is assumed to be 20% for single name subordinated CDS and 40% for senior financial CDS.

What are the implications and "unintended consequences" for the financial credit markets? CITI's note gives some additional insights:
"Likewise, lawmakers may feel that the decline in liquidity in sovereign CDS following the ban on naked shorting may not seem to have had an immediate effect. But here too we would argue that this is mostly because we happen to have been in a rallying market, and that the future consequences may stretch well beyond just CDS itself. If investors become forced sellers following downgrades to junk for Spain and Italy, as we think quite likely, the lack of liquidity in CDS would exacerbate the movement in bonds. While some liquidity remains in single-name sovereign CDS, the effect on the SovX index of the shorting ban has been quite dramatic (see graph above on Itraxx SOVX weekly trading). 

The potential problem in bank CDS is almost as large. Although net notional outstandings for single-name European bank CDS are only $68bn,7 DTCC data show that traded volumes are some $36bn/month. This compares with gross turnover in €-denominated bank bonds of only €15bn/month (on €600bn of outstandings). CDS plays an extremely important role in terms of index trading and price discovery, and is often actively used as a hedge for bond portfolios by investors because of its greater liquidity. 
These issues over triggers and deliverables could all too easily jeopardise the validity of the CDS market as a hedge. If it were accidentally “killed off”, the consequences for the bond market would be severe. Unlike in sovereigns, where the underlying cash market has normally been more liquid than CDS, in the corporate market liquidity is heavily fragmented. Without the signaling and hedging role of an active CDS market, bond transparency would fall, trading would become more lumpy, and ultimately the cost to bank issuers would increase, as an increased illiquidity premium became factored into spreads. This hardly seems a desirable outcome." - source CITI

On a final note, as far as Europe is concerned, whereas the US was all about the "fiscal cliff" recently, we think investors in Europe should be focusing on the potential "earnings cliff" given we think analysts are somewhat a little bit too optimistic in their expectations. As an illustration Dutch KPN fell 18% recently to its lowest level since September 2001, following a 4 billion euros right issues in conjunction with earnings well below expectations, leading S&P to downgrade the credit to BBB-, one notch above junk - source Bloomberg:

"Everyone's a millionaire where promises are concerned." - Ovid

Stay tuned!