News analysis

Asian bank derivatives look quite tame

As the collective fear over banks' deteriorating health escalates, buying insurance to protect against non-payment has become one of the best investments in the financial sector. Yet for all the negative headlines about Chinese lenders, their credit default swaps (CDS) still look pretty tame.

A person who bought US$10 million of credit default swaps on Standard Chartered one year ago, for instance, would now be able to resell that contract for US$23 million (S$32 million). The same investment in the bank's shares would be worth US$4.3 million.

A similar pattern holds true across most banks globally.

The Markit iTraxx Europe Senior Financial CDS index has increased 127 per cent over the past 12 months, while the MSCI Europe Banks index is down 31 per cent.

In Asia, while bank derivatives have risen as well, they don't seem to fully reflect all the hand-wringing embedded in headlines.

Contracts protecting the Bank of China's debt against default are up 54 per cent over the past 12 months to 186 basis points, while its Hong Kong-listed stock has dropped 35 per cent in that period.

The rise in the Bank of China's credit default swaps is not overly steep compared with the moves for Standard Chartered. ST PHOTO: JAMIE KOH

A 54 per cent rise sounds like a lot, but compared with the moves for Standard Chartered or Deutsche Bank, it isn't. The Bank of China's CDS are still 16 per cent below their peak earlier this month of 221 basis points, which was the highest since June 2012.

One could argue that because credit default swaps on ING are only at 85 basis points, and the Dutch lender is rated Baa1 at Moody's, three levels below the Bank of China, swaps on the Chinese lender are too cheap.

The cost of insuring European bank debt against default over the past 12 months has risen 127 per cent. It doesn't work that way.

CDS spreads are a barometer of perception. As people become more fearful of what might happen in the future, they purchase default swaps to hedge their exposure, pushing spreads up. Like insurance, very seldom is a contract actually executed. Money is made from reselling the contracts at a higher spread. In other words, buying CDS is equivalent to betting that the news surrounding a company is going to get worse rather than better. And right now, the news surrounding Chinese banks isn't exactly glowing.

While Chinese bank stocks are as cheap as they have ever been, Mr David Herro, who manages about US$30 billion at Harris Associates, does not think they are a buy yet.

Mr Kyle Bass, another high-profile investment manager, is engaged in a public battle with analysts in China about the real level of soured loans at Chinese banks. While it may be less than the 9 per cent Mr Bass estimates, it is also probably more than the official reported figure of 1.7 per cent.

These sort of debates brew distrust, which usually means more buyers of CDS and higher spreads.

Plus, any time investors begin to question the health of European banks, as they certainly are now, default concerns start to swirl faster in Asia.

It all suggests that gauges of fear in this part of the world aren't as elevated as they should be. Chinese bank CDS spreads don't appear to reflect the headlines.


A version of this article appeared in the print edition of The Straits Times on February 27, 2016, with the headline 'News analysis Asian bank derivatives look quite tame'. Print Edition | Subscribe