Betting on Default Investors Lose Faith in Italy

A recent surge in the purchase of credit default swaps shows that an increasing number of investors believe Italy is in trouble. Some experts doubt the CDS providers would be capable of paying out if Rome were to default.

Italys Prime Minister Silvio Berlusconi: Investors are increasingly betting on an Italian default.

Italys Prime Minister Silvio Berlusconi: Investors are increasingly betting on an Italian default.

Yields on Italian government bonds, it seems, aren't the only things rising in the country this summer as investors begin to ask if Italy will be the next domino to fall in Europe. Currently, more bets on credit defaults -- so-called credit default swaps (CDS) -- are being taken out on Italy than any other country.

With a gross CDS volume of almost $306 billion (€212.69 billion), the country is currently in the lead, ahead of Brazil ($179 billion) and Spain ($176 billion). Indeed, the desire among investors to bet on a default in Italy and Spain appears to be growing. Since mid-June, the bets against Italy have risen by $23 billion and those against Spain by $18 billion.

The figures come from the Depository Trust and Clearing Corp., the American trading platform, which, according to its own statements, is responsible for 98 percent of the global CDS transactions.

Still, if a country does default, it doesn't automatically mean that the entire value of a CDS would be paid out. This is because betting partners often hedge the bet through offsetting transactions. So the maximum amount that would have to be paid out if Italy were to default would be about $25 billion. For Spain, that figure would be $18 billion.

But even at these amounts, experts have expressed doubt over whether the participants would actually be able to come up with their share of the bet. If some of these betting partners were unable to pay, it could rattle the markets even further. The reason is that a CDS works like insurance: Creditors purchase them in order to provide protection in case their debtor defaults. But the CDS market is also unregulated, and the derivatives played a role in the global financial meltdown in 2008 after the subprime mortgage market collapsed.

CDS securities are also purchased by hedge funds that don't have any vulnerable state bonds on their books. The hedge funds are speculating that the increasingly threatening financial situation in the debtor countries will lead to an increase in CDS prices and that, eventually, they will have to be paid out.



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