How Likely Is Bank Default?

How much bad news has been priced into bank debt and equity prices, and are markets getting too pessimistic?

The best way, Matt, to assess this is to look at the cumulative probabilities of default (“CPD”) implied by current credit derivative swap (“CDS”) spreads. The CPD is derived directly from CDS spreads, with a couple of additional assumptions used in the calculation (one is the likely recovery rate on defaulted debt, usually set by convention at 40%, and the other is a guess at the likely trajectory of interest rates over the calculation period).

The CPD is set as a percentage, and tells you the market’s current assessment of a particular issuer’s likelihood of default over the life of the related CDS contract (usually five years, so the CPD is calculated over the same period). So a 30% CPD means that the market is telling us that there’s a three in 10 chance that the issuer in question will have defaulted on its debts before five years from now are up.

Here’s a table of some leading bank CDS spreads (on both senior and subordinated debt), and the implied 5-year cumulative probability of default on the senior debt, taken from earlier today and supplied to Index Universe by CMA Datavision, the credit market specialists.

What’s of interest? First, notice that the 5 year CPD on some major continental European banks is in single figures, with the exception of Unicredit. UK banks are generally riskier, with Barclays, at 14%, riskier than Lloyds TSB and HSBC. US banks have a generally higher probability of default, with JP Morgan the least risky and Morgan Stanley and Citigroup top of the list, with a nearly one in four chance of default on senior debt over the next half-decade.

Putting these figures into some kind of perspective, it’s worth reiterating that the overall levels of bank default risk are still some way below the peak levels of last September, at the time of the Lehman default. If one takes into account that bank equities are trading at or very near their lows for the bear market so far, this is telling us that the many government support packages for the financials are having some effect in propping up bank debt prices.

At the same time the CDS spreads on government bonds have jumped since last autumn, as public debt is increasingly used to underwrite private liabilities.

The last few days’ dramatic rise in Irish government CDS spreads show this trend in microcosm. They’ve reached over 350 b.p. at five years, by far the widest of the Eurozone governments, as the Irish government injected further capital into Anglo-Irish bank and the Bank of Ireland. The markets are calling into question the sustainability of Ireland’s policy of underwriting all its banks’ deposits.

This is the conundrum facing investors – can governments keep up their desperate attempts to avoid bank failures without ruining their own creditworthiness?

You rightly point out, Matt, that the US treasury is still able to finance itself, via 10-year bonds, at under 3% per annum. So perhaps there is no major concern yet about the sustainability of the US government’s finances. Having said that, CDS spreads on US sovereign debt are creeping up towards 1% per annum, and are much higher than a year ago, so some investors are indeed getting concerned.

How should ETF investors position their portfolios?

If you think that the concerns over the financial sector are overdone, you should probably prefer bank equities to bank debt, as you’ll get an extra kicker during any rebound from equities’ inbuilt volatility.

If you think that things are going to get worse for the financial sector, the two db x-trackers ETFs offering short exposure to senior and subordinated bank debt spring to mind.

And if you’re really bearish and think that the creditworthiness of governments is going to crack, you probably want to use one of the inverse government bond ETFs, or take a short position in one of the conventional government bond trackers – and buy precious metals as well.