As can be noted by a comparison between the values of Table 1 and those of Table 2, according to the markets of the CDS, the probability of sovereign default is held to be greater than the biggest world companies.
The reason is easy to guess: the prices of the sovereign CDS reflect a growing sovereign risk (due to rescues, coverage on hazardous assets, and of guarantees furnished to strategic companies, guaranteed with the purpose of allowing to the latter to be able to go into debt without having to undergo reduction of credibility). Obviously, the phenomenon is also valid for Italy, as one always deduces, taking as a base, the data of the Depository Trust&Clearing Corporation (DTCC).
To safeguard reputation and sustainability of ones own national banking systems, the States see their sovereign credit risk increase and, contextually, worsen that of the banks. This is one of the reasons at the bottom of the growing demand for corporate bond issues, in which the differentials of price (spread) already include the premiums of risk of default negotiated by the market of the CDS.
This representation of the risk of insolvency attributed to Italy is, without a doubt, worrying, but it keeps account of a ‘sentiment’ present in a specific market (that of the CDS), to be considered reliable only for its part of “insurer of the credit risk”.
The CDS are, in fact, only a “barometer”, a useful instrument to understand the hazard that one assumes in making a certain investment. When, instead, they are taken as indicators on which to wager, neither the aggregate information of the “notional” value of the CDS contracts, nor the CDS spread (price of a CDS) must be considered representative of the unreliability of a Country.
Many, on the contrary, would like a message of this nature to be believed, and this aspect makes a new need of evaluation of financial intelligence very evident.
From the objective analysis of the CDS market data that can modify or forestall the probabilities of default of a sovereign State or of an enterprise cannot not be deduced. The indication that one can pick up from the reading of the trends of the premium of a CDS must be, instead, “weighed” with further elements, for example, the evaluations attributed by the rating agencies, or the statistics of the variable “fundamentals” of the internal economy.
Beside a quantitative analysis should be added also a qualitative and interpretative analysis, relative to the social indicators and welfare state, to the development and to the borrowing structure, to the situation of the internal financial system and, above all, to the evaluation of the political stability as indicator of the “temporal coherence” (in the sense indicated above by Kydland-Prescott) of the announced economic policies. But this, let us repeat, it applies only in the utilization of a CDS for the coverage of a credit risk. When, instead, a wish is detected to “contrive” to bring about an indicator of potential bankruptcy in the CDS, it would be plausible to consider the presence of distortions or alterations, on the market, of the prices realized from flows of obscure negotiations.
Evaluations of financial intelligence must start from the mechanisms at the base of a CDS. The technicalities to which I am forced to resort could be beneficial in helping to better understand a concrete application, first physiological, then pathological, of the credit derivative. In this article, the bankruptcy of Lehman Brothers will be used as an instrument to show how the CDS market, when used in its physiological form (for the insurance of credit risks), shows an elevated level of resilience (9) . Vice versa, the pathology arises when the information present in the CDS market, a large and extremely volatile amount, is used to gain profit from the difficulties in which a company (or a State) finds itself.
In this sense, we shall open a window onto the risks of insider trading in the CDS market, a new application of a traditional threat to the financial intelligence.


Technical focus on the credit default swap (CDS)


What creates the need to purchase a credit derivative? Unlike State bonds (a case with which we shall deal subsequently), there exists for the corporate and municipal bonds the risk that the payments of the coupons or the capital are not made according to the provided for modalities. (10) . For these bonds a distinction between “promised yield” and “expected yield” must be made.
A bond can promise a yield of 12%, but if there were a probability of failed reimbursement in capital account or of failed payment of the coupon, its “promised yield” must deduct a risk premium. The difference between “promised yield” and “expected yield” is, therefore, the credit risk premium that will be added to the rate of interest provided for the bond issue.
In the CDS, (A) (protection buyer) asks protection from (B) (protection seller) with respect to the risk that verifies a default, before the expiry of the swap (so-called “credit event”) (11) , in relation to a credit that (A) holds towards (C) (“reference entity”). For this (A) pays a periodic premium, the CDS spread, to (B),who takes upon himself the credit risk towards (C). The spread is generally paid quarterly until either the insolvency or the expiry of the bond of reference is verified.
In schematic form, a subject (A) purchases a protection from subject (B) for 5 years (CDS classic), coverage for the probability of insolvency of an issuer of debt (C). The notional annual value insured is of 10 million dollars, the annual swap spread paid is of 300 base points (12) 1 and the rate of established recovery is of 45% (13) .
At the expiry of the first quarter, subject (A) makes the first payment equal to 75 thousand dollars (10 million * 0.03 * 0.25) (14). At the fourth month, the issuer of reference (C) results insolvent. In that moment, the clearing that will conclude the swap contract will occur:
the seller of protection (B) will repay (A) for 5.5 million [10 million *) 100%-45%)];
the purchaser of the protection (A) will pay (B) the premium (LIBOR + commission starting from the date of the last payment) equal to 25 thousand dollars (10 million * 0.03 * 1/12).
We have said that the credit derivatives originate to facilitate the negotiations of the credit risk and the diversification of same among the market operators.
Let us look at a concrete use, hypothesizing that a bank has given a loan to a company client that produces equipment for oil fields (15). Although receiving a regular flow of payments on the loan, the bank considers that it has an excessively elevated credit exposure towards the oil commercial sector, risking the repercussions of a fall in oil prices. (16) .
In diversifying the risk, the Bank decides to introduce into its portfolio assets tied to the auto sector (chosen because it is not correlated to that of the oil sector) through two operations:
the Bank contracts a CDS with a dealer, covering itself from the non-fulfilment by the company for the oil services (17) ;
the bank contracts another CDS with a hedge fund, in which the Bank promises to indemnify the fund against losses on a portfolio of loans to the auto dealers. For this protection, the hedge fund pays a monthly payment to the Bank.
After these two transactions, the Bank has diversified and balanced its portfolio substituting the credit risk of a portfolio of loans to the automobile sector with a loan to the petroleum industry (18) . In this sense, the derivatives act as an efficacious instrument of risk management, reducing the profile of the credit risks of two financial intermediaries. The importance is to maintain a tie with the real component of the economy.
The fall in the reputations of the rating agencies has, recently, induced the banks and companies to “link” the agreed rates on the lines of credit to the “CDS spread” in the covering of default, or rather, to the premiums requested for the underwriting of CDS contracts.
In this way, the credit institutes have started to debit the same cost to the companies, which should sustain the companies themselves for coverage from the risk of default, in the case that they should opt for an insurance of their credit through CDS. In fact, a CDS is similar to insurance, insomuch as it is based on the probabilities of default of credit bonds of reference (loans, mortgages, bonds issued by companies or governments), with a part that “purchases” the protection against insolvency in its credits, and the other that “sells” this protection.
The CDS are not recorded among the liabilities of the balance of the seller of the protection swap.
This “outside the balance” nature of the contract (typical of the derivatives) can generate “systemic liabilities” the moment when an investor acts as seller of protection in a high number of contracts without revealing such agreements, accumulating a very strong exposure to potential insolvencies “invisible” to the regulatory bodies and to the other operators on the market (19).
The total exposure of a seller of protection comes to the point of having no more limits and a few episodes of insolvency can deplete the capital of an over-exposed investor. In such cases, the underwritten swap contracts become void leaving the purchasers of the protections correspondingly exposed to further insolvencies (so-called risk of the counterpart).
In addition to the risk of the counterpart and the market risk (the risk, that is, that the CDS contract increases or diminishes in value), there are, at least, another two non-systemic risks: (1) the legal risk (the possibility that the counterparts find themselves involved in legal actions) and (2) the assignment risk (risk against cession, which refers to the danger that a counterpart makes a cession of the CDS without the consent of the other part). Although many agreements of CDS require the consent of the counterpart before the cession, the practice of transfer of CDS without consent (no-consent assignment) has grown to around 40% of the volume of the CDS negotiations. This way of acting makes the identity of the counterparts uncertain, undermining the risk evaluations of the counterpart (20) .
Recently, the financial catastrophe has never seemed so close, with the quasi insolvency of Bear Stearns (avoided, thanks to the rescue by the United States Investment Bank, JP Morgan, taking over also in the derivative contracts of the former, with the backing of the guarantees furnished by the United States Government and of the American International Group – AIG, societies of insurance which had underwritten protections on a vast scale (avoided, thanks only to a massive governmental intervention). Analogous support, however, was not ensured to Lehman Brothers by the U.S. Government, but strangely enough, the CDS market has not collapsed.


Physiology in the CDS market: resilience
and efficiency in the bankruptcy of Lehman Brothers

The experience of Lehman Brothers is useful to show the high degree of resilience of the CDS market. In fact, notwithstanding the paralysing impact of the bankruptcy of Lehman on a large number of markets, already two months afterwards the CDS market seemed to have survived relatively in tact. On the 15th September, 2008, Lehman announced the wish to avail himself of the Chapter 11 (21) , declaring debts (bonds and banking) for 768 billion dollars against activities for 639 billion dollars. This marked a turning point in the history of the CDS because it was the greatest credit event which had put the functioning of the market to the test. There has never been a CDS credit transaction of the proportions of the LehmanLehman debt (circa 400 billion dollars), and for this reason there was much anxiety over the fact that one or more great institutional counterparts could be in default of its obligations, provoking a domino effect.

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The preoccupation connected to the dislocation of Lehman was, initially, focussed on the role of intermediary and important counterparts covered by the Bank in the CDS market. The Lehman bankruptcy had triggered the mechanism of the CDS tied to the issues of its bonds in circulation. On Sunday, 14th September, 2008, on the eve of its declaration of bankruptcy, it held an emergency assembly of negotiations to allow the principal counterparts in the CDS market to adjust the exposures towards the merchant bank. The fears over a domino effect increased further on the 15th September when, at the end of the day, the credit ratings of the American insurance giant, AIG, which presented conspicuous positions in CDS (22) , were lowered by all the principal evaluation agencies.
The downgrading, in its turn, started a series of requests for supplementary guarantees on the part of the counterparts of AIG, as well as, the advanced cessation of new contracts. As a consequence of this, during the day of September16th most of the principal CDS indexes rose above the maximums reached in March, then to fall solely because of the speculations that AIG was to receive public assistance.
Contextually, new critical situations have emerged relative to the exposures of Lehman, in particular, when the Reserve Primary Fund, an important U.S. mutual fund active on the monetary market, eliminated from the balance, 785 million dollars of short and medium term notes issued by Lehman (23) . This triggered off in the United States, the request of a volume, without precedent for extinction and repayment of quotas of monetary mutual funds (24) .
Notwithstanding all these events, on the 22nd October, 2008, the Depository Trust & Clearing Corporation (DTCC) completed the automatic liquidation of all the CDS premiums relative to Lehman. After the netting operation, actually, only 5.2 billion dollars were transferred among the parts and there were no public announcements of institutions that declared insolvency with regard to their bonds deriving from the liquidation of the premiums.
With this one cannot deny that the CDS contracts regarding Lehman have not increased the volatility of the market. Only circa 150 billion dollars of CDS contracts have been guaranteed, while the remaining 250-350 have generated absence of financial coverage.
Notwithstanding this, there have been no indications of systemic risk deriving from the commitments of Lehman connected to the CDS, both from the point of view of the dealer and the entity of reference (with 72 billion dollars in notional CDS underwritten to the coverage of its default (25) . This liquidation has been defined as “the non-event of the year”. A never more appropriate definition, inasmuch as the value of the Lehman CDS rose (and Lehman was going towards insolvency), the sellers of CDS had already paid off the greater part of the contractual value to the counterparts. Consequently, the “non-event of the year” had concerned, simply, marginal liquidations relative to the day in which Lehman actually declared bankruptcy, a situation, after all, already known to the CDS market. In the absence of a world clearing house for the CDS (26) , the greater part of the capacity of resilience of the CDS market is ensured by the daily adaptations of the guarantees collateral to the varying of the value of the agreement (with the increase or diminishing of the possibilities of insolvency of the reference entity. This practice helps to contain, but not limit, the risk of the counterpart. For example, if a CDS contract increases in value due to the cause of the possibilities of default of the reference entity, the seller of the CDS must furnish greater collateral guarantees. If the contract diminishes in value, the collateral guarantees are returned to the seller of the CDS. This practice of liquidation, which considers the value of the bonds according to the market quotations (“mark-to-market”) ** on a daily basis, reduce the possibilities of arriving at a single and heavy final payment in the case in which an imminent possibility of insolvency is expected. The standard practices similarly show that the counterparts offer further collateral guarantees in the case in which their financial condition should worsen. For example, a company that has received an evaluation of the type “AAA” (with minimum risk) from a rating agency of a national level will offer a smaller number of collateral guarantees compared to a company evaluated type “BBB”. Nevertheless, on the basis of the agreement of the CDS, if that same company evaluated type”AAA” is downgraded, further collateral guarantees are often requested (27) . The CDS market presents characteristics of resilience when they are not present- In a diffused manner, speculative activities try to take advantage and profit from the destabilization of one or more parts. When the transactions, finalized in a dominant manner to assure a credit risk, they go to constitute a system, the mechanisms of clearance will benefit from the implicit incentives for the protagonists who are interested to avoid insolvency and bankruptcy. Pathology in the CDS market: insider trading and sovereign debt Last March 6th, a national daily newspaper reported a news item concerning the launching of the “First to default basket”, a financial product structured by JP Morgan, with expiry of 3 years, quarterly coupon, and only liquidation at the moment of default of the first of the eight Countries included in the basket. The diffusion of this product was said to have been accompanied by the diffusion of a negative confidential report on Italy. In the afternoon of the same day, JP Morgan called for the intervention of CONSOB, denying the existence of both the report of the Italian sovereign debt which supported the possibility of a default of Italy, and of the financial product that implied (or indicated) a negative view concerning the credit of the Italian Republic. The credit swaps were created by Blythe S. Masters – the then analyst of JP Morgan Chase &Co. (today member of the Executive Committee of the Merchant Bank) – more than ten years ago with the scope of guaranteeing a coverage against losses on bank loans. But even considering the experience and creativity of JP Morgan in the derivatives sector (28) , the “Basket Default Swaps” (BDS) are a common (and well know among the operators of the sector) application of the CDS to an underlying basket of assets subject to credit risk. In the BDS, the buyer of the protection protects himself in relation to the default by a series of assets at an inferior cost to that which would hold assuring himself of each asset singularly. The difference between a BDS and a CDS lies in the fact that the event that triggers the payment of the protection is the nth credit event of the specified basket of reference entities (the first event in the First-to-default [nth=1], the second event in the Second-to-default [nth=2], and so on).

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The buyer of the protection receives his liquidation in the case of default of one of the assets in the basket, but not receive further clearances for each successive default. A similar product can furnish an adequate protection if the probability of multiple bankruptcies is very low (29). True or false as it may be, due to these rumours, relative to both the report and to the financial product (where, probably, the CDS of Italy was fixed at 130, also quite a low premium), the CDS in 5 years of Italy quoted at New York underwent “leapt” to 201 points against the 195.6 of the previous day, increasing, by 5 base points the price, to protect itself from an exposure of 10 million Euro on Treasury Bonds. This example represents a pathological application of the credit derivatives market. Excluding any fraudulent intention, whatsoever, by the newspaper, in general, the asymmetry in the information held by the operators generates, in fact, incentives to the insider trading favoured by the fact that the majority of its operators are insiders (banking officials, specialists in loan practices, who can divulge internal information such as the buying plans or cessions of activities, to CDS dealers; creditors in possession of confidential information concerning the probabilities of insolvency of a certain society can try to seek advantage from the “privileged” information by buying a CDS on that society from a less informed counterpart). In the case of the credit derivatives (and of CDS, in particular), the dealers are motivated to exploit the privileged information in a greater measure when there is negative news regarding a certain credit exposure. The more the probability of insolvency is accentuated, the more the risk of insider trading grows. The presence of insider trading implies that the flow of information from the CDS market to the share market is greater: for the States (or for the businesses) the moment in which the probability of situations of trouble is highest, and the potential gains, in terms of hedging, are significant; - when there is a high number of potentially informed insiders. Pension funds, insurance and hedge fund societies can speculate on all these components to the point of “betting” on the “bankruptcy” of a determinate State or company subject. This situation accentuates the “risk of the counterpart”, also for the use of the CDS to “conceal” the credit risk to the markets not having to justify the positions adopted in the states of property (30). When the CDS spread depends only on the credit risk (in its turn function of the probability of default and the expected losses, given the default), the CDS spread and the bond spread (difference between the yield of the bonds issued by the entity of reference and a benchmark adopted as risk-free) must be approximately equal. There exists a linear relation between the two spreads. The difference, defined as default swap basis, is positive when there is a risk premium (CDS spread > Bond spread). In this sense, the advantage of a CDS compared to the rating is that the CDS “quantifies” the risk and allows it to be added to the rates of interest. An enlargement of the spreads between CDS and bonds could reflect a deterioration of the quality of the credit of the bond issuer, but also risks of a different nature connected to the expiry of a bond (if there is an imbalance in terms of structure of the expiries between activities - concentrated on long term - and liabilities - concentrated on the short term) or in the currency in which the debt security is expressed (when the liabilities are principally denominated in foreign currency, while the activities are in internal currency, a sudden change in the nominal and real value of the internal currency can generate heavy losses). If the entities of reference fulfil their contractual obligations, the CDS are a zero sum game : what the seller loses, is gained by the buyer. The “risk of the counterpart alters this symmetry. Considerations and conclusions There is a current of thought in Europe that sees, with insistence, the possibility that a Country of the Eurozone could go bankrupt. The perception of the markets towards a risk of sovereign default in the Eurozone is, undoubtedly, much higher than in the past. On Wednesday, last March 11th, in London, during a conference call of the Elvetica Bank UBS to present the outlook of the institute and the strategies with respect to the worsening of the crisis, they spoke of “scenarios of an eurozone from which, a member would, very shortly, be forced to leave”. Last January, the CDS rate at 5 years on Germany was of 44 base points, on France of 51 base points, on Italy of 155 base points and on Greece of 221 base points. Much higher values than those registered to date. Together with the medium level of the premiums of sovereign default risk, also the differentials (spread) relative to the issues of debt of Countries of the Eurozone have grown. Last January, the bond spread with respect to the German Bund at 10 years were of 88 base points for Austria and Belgium, 52 base points for France, 90 base points for Spain, 105 for Portugal, 135 for Italy, 171 for Ireland and 233 for Greece. Even considering the non-comparability of the two values, being referred to different expiries (5 years for CDS and 10 years for the sovereign bonds) and on different markets (regulated for the State securities, over-the-counter for the CDS), their dimension is, however, worrying. Also if in Europe, the English saying is becoming always more valid “you broke it, you fix it”, an evaluation of financial intelligence suggests, however, to look at the overall situation and not at the details of particular Countries. For example , the German refusal to share a common responsibility for the liabilities of a single Country, as well as the non-consideration of the hypothesis of jointly issued bonds of the European Treasury Ministries represent positions, however, irreproachable (insofar as they are in full respect of the spirit of the EU Treaty), less opportune in the particular economic circumstances. It is not necessary to wait until a Country goes bankrupt for it to undergo a speculative attack. The awareness of the difficulties that Germany, the monetary benchmark of the Eurozone, is sufficient, in particular: - the vertiginous increase of the notional total of the sovereign CDS, which has pushed the rise of Berlin on the list of the first 15 reference entities (as in Table 1) and of the sovereign CDS rate of Germany to 39%, in the same month, in February; - the crisis of the Pfandbriefe market (31) exacerbated by the extension operated by the Government of Berlin, of the guarantees to bonds issued by German banks, which could have reduced the differential between the two options for the investors (32) ; - the strong exposure of the German banks towards the more in debt States of the Eurozone (Portugal, Italy, Ireland, Greece and Spain) equal to 25% of the German GDP (against a contained 4% of Italy); - the need of coordination in the issuing of State securities, hope for by the German Chancellor, Angela Merkel, after the difficulties registered in the auction of the Bund at 10 years of the 7th of last January and of the 10th December, 2008. In fact, in 2009 is awaited a wave of issues for a total of 3 thousand billion dollars, the triple of 2008, necessary, to a great extent, to finance the rescue plans of the banks and of support to the economies. Therefore, vigilance and cooperation are in the interests, above all, of the “strong” Countries of the Eurozone (understood as such for their greater internal fiscal discipline) to avoid the diffusion of “distorted” information with the only objective of striking the reliability of a “weak” Country. In fact, the resilience of the Eurozone is perceived as dependent on the stability of its more fragile Member (as the “weak link” of the system). The difficulty of a Country in coping with its commitments in terms of debt service would echo swiftly on the securities markets of all the other Countries, including the stronger ones, jeopardizing the very stability of the European banking system. Psychological effects (the herding behaviour) and the inter-dependency in the European banking system are at the bottom, therefore, of the risk of contagion. Notwithstanding, the cumulative probability of default extracted from the CDS maintains Italy at high risk, in short, it seems that others have much worse problems. Seen as a weak Country for the excessive internal debt, Italy is undergoing an unjustified campaign of disparagement sustained also by information from the CDS market. The groundlessness of such attacks could be supported also by: the success in the auction of securities at medium and long term (BTP 3 year and 10 year) for over 10 billion securities, registered at the end of last February. A decisively better placement than that done in the same week relative to Irish and Portuguese bonds: - the positive consideration by Moody’s, relative to the private sector of Italy, of a very much more contained private debt than that of other Countries, a circumstance which could favour, on a de-leveraging, a minor impact on the overall economic growth. The problem of the financial market is on its dependence on the emotions, and the greater this relation is, the more the formulas of calculation are evanescent. Indeed, in periods of financial turbulence, the emotional component is so strong in the assessment of the risk of certain Countries that, for some of them (like Italy) the risk of default is considerably overestimated. The emotionality of the market generates an “extra-spread”, simply due to the negative prejudices towards certain Countries (like the “politeness” of a certain European press – quote “the inclusion of Italy among the PIGS”, an acronym of unequivocal meaning, already including Portugal, Ireland, Greece and Spain), causes the effective spread to be higher compared to the spread that a more objective analysis of the risks could suggest. The incentives to the activity of insider-trading, intended to damage the reputation of a “weak” Government, are more in (partial) absence of sharing of information. In particular, with reference to the credit market, the more the probability of insolvency is accentuated, the more the risk of insider trading increases. To counteract these risks a Government must be able to dispose of elevated informative and cognitive capacity, which only an action of financial intelligence (not only referred to the section ex Law 124/2007, but extended to all possible institutional components, such as Bank of Italy, CONSOB, Ministries) can guarantee assuring the right synergic sharing of information and resources.