Back on September 12, we examined Italian bond spreads and CDS. At the time, 5-year Italian CDS was approaching 5% and 10-year Italian spreads to Germany were approaching 4%. Now that these levels are once again being breached, as shown in the charts below, we revisit why these markets may be reaching a tipping point.
LCH Clearnet is the main clearing house of European bonds and CDS. In October 2010 they released a circular which formalized some of their guidelines for margin requirements:
• LCH.Clearnet Ltd monitors the yield spreads between 10-year bonds from each sovereign issuer and benchmark 10-year AAA government bonds. We would generally consider a spread of 450 basis points over the 10-year AAA benchmark to be indicative of additional sovereign risk and LCH.Clearnet Ltd may materially increase the margin required for positions in that issuer. As a guide, materially would likely mean an increase in the order of 15% of position size, with further material increases in margin charged as the spread deteriorates further. We will also consider whether additional margin is required from indicators in CDS prices or Market Implied Rating data.
• Where a sovereign issuer is downgraded to sub-investment grade by a major rating agency we would generally expect market liquidity to be significantly impacted and may seek to apply additional margin for positions in that issuer.
• If a Clearing Member and sovereign issuer subject to increased ‘jump-to-default’ risk are highly correlated (‘wrong-way’ risk) we would also seek additional margin.
When Irish spreads breached the 450 basis point level, LCH Clearnet responded with a margin hike. A second and third margin hike were announced when spreads remained consistently over 500 basis points.
While the bullet points above would lead us to believe that Italy may be close to a margin hike, these rules should not be considered definitive. In a world where a 50% Greek haircut can be deemed voluntary, anything is possible. In fact, officials at LCH Clearnet recently commented on the guidelines above by saying, “It is important to note that it is an outline guide to our approach to managing risk. Our risk managers will use their judgement to determine whether, and if so how, we will utilise the framework.”
The ECB clearly understands the importance of the 450 basis point spread. They have been rumored to have bought large chunks of Italian debt in an attempt to hold this level. The fear is that, if this measure only postpones the inevitable, LCH Clearnet will have to make some difficult decisions in the near future. Based on past precedence, it would appear as though Italy is once again dangerously close to the tipping point.
Source: Bianco Research
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