OTC #7 The Collateral Boogeyman – realism, Portuguese edition

Gillian Tett at the FT reports that

…the Portuguese debt management agency formally announced in an e-mail that it would start posting collateral (such as cash or government bonds) on derivatives trades that it cuts with banks. It is intended to have a “positive effect” on its financing costs, and reduce “credit exposures”, it said. To onlookers, this might all sound dull and technical.
But in reality it carries considerable symbolic and practical significance. This week’s is just one sign of a much bigger paradigm shift about how investors and risk managers are now re-evaluating their assumptions about “safe” public sector debt.

Yes, it signifies a paradigm shift in how Portugal’s creditors view its debt. But it also signifies another paradigm shift as society gradually comes to grip with accurately assessing the costs of credit implicit in derivative transactions and compares this with the explicit cost of collateral.

As we have written in an earlier post, when a derivative contract is written without requiring collateral, the dealer bank is implicitly extending credit for potential losses incurred by the counterparty. It has to charge for that. In the case at hand, the bank itself finds it expensive to have that credit on its books or to offload it by hedging in the credit default swap market.

It is one thing to hedge the risk of a firm in an industry that has many players. At least the common factors that impact that industry are readily available for trading through alternative CDS contracts. It is another thing to hedge a risk that is a lot more specific, which involves finding someone who is willing to bear that risk in an inherently thin market. Moreover, markets tend to dry up when things get rough with the number of active players shrinking to a mere handful. Evidently, search and contractual costs are high in an imperfectly competitive market such as the CDS market for Portuguese risk when the country is close to the abyss. At this critical juncture it is crucial that the high CDS spreads do not feed a vicious cycle of higher rates that prompt even higher CDS spreads. What this means is that it may be better for the Portuguese government to post collateral on the derivatives transactions, and avoid buying its credit on costly terms from the dealer bank.

The question is, however, how much collateral has the Portuguese government still in store?

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