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Italy’s humpy swap curve and Berlusconi’s time-bomb politics

The price of credit-default swaps can be used to estimate the probability of sovereign default. This column examines the case of Italy, looking at how default risk varies across maturities and how this has evolved since January 2011. It suggests that markets are pricing in a heightening of risk two years from now – mostly probably due to political tensions and the risk of deadlocked reform.

Former prime minister Silvio Berlusconi's Partito della Libertà is bitterly divided as to what to do with Italy’s new prime minister, Mario Monti.

  • The doves (ex-Christian Democrats) favour a loyal support to Monti.
  • The hawks (ex-socialists and ex-fascists) are crying shame for the "suspended democracy" and the "the bankers’ coup".

To keep his party together, Berlusconi has opted for a ‘time-bomb strategy’.

When the ex-prime minister resigned, he said the bomb would go off in June. That would mean Monti has until June or so to accomplish the dirty job of passing the necessary reforms. After that, Berlusconi's party will withdraw its parliamentary support and thus bring down Monti’s government. The explosion date may have been pushed back. Possibly after realising that Monti’s new government is backed by 82% of Italians, Berlusconi says Monti now has until 2013.

So much reform, so little time

Yet the date could change again. The new government’s consolidation and liberalisation measures could cause short-term pain. Should the economy suffer in the short run, as is very likely, Prime Minister Monti’s popularity could decline. In this case, the temptation for Berlusconi to withdraw his support and go to a new election – in the hope of a comeback – would prove difficult to resist.

The Italian reform agenda is long. It includes tax reform, labour-market reform, pension-system reform, privatisations, cuts in the cost of politics, and liberalisation of the goods and services markets. How could anyone think that six months would be enough to complete such an endeavour?

In fact, markets believe otherwise, as an analysis of Italian debt prices reveals.

Estimating market default probabilities from market data

Most nations’ sovereign debt can be insured with contracts know as credit-default swaps (CDS). These contracts oblige the issuer of the CDS (often a bank) to buy the defaulted bond at a predetermined price (usually face value); the name comes from the fact that this is a cash-for-bond swap. The contracts are traded, so when default risk rises, the contracts get more valuable and this is reflected in their price.

Since CDS have been issued for the full range of Italian sovereign bond issues, we can estimate default probabilities from the CDS prices – if we assume what the cost of the default will be if it occurs.1 To this end, we use the daily spreads of CDS on the Italian bonds with maturities ranging from 1 to 10 years. These insurance contracts are continuously issued, here we focus on contracts signed between January and November 2011.

Assuming a 40% recovery rate in case of default, it is simple to find the implicit probabilities of default at different maturities. The result is the time-profile of the market’s estimates of default probabilities.

Time profile of one-year default probability

The results are shown in Figure 1. The picture gives two types of information. The first is how default risk varies for a given maturity – say one year out – from January to November of this year (move from southwest to northeast in the chart along one of the maturity lines).

This shows us how markets have changed their perception of Italy’s medium-term prospects over the course of 2011.

  • What we see is how perceived risk at the one-year horizon jumped between April and June 2011. The probability of a default within a year climbed from below 2% to above 6%.
  • The one-year risk jumped again between August and November 2011, while Berlusconi’s government was paralysed by conflict on budget cuts. The probability reached almost 8%.

Figure 1. Italy’s term structure and default probabilities

Source: Authors' calculations using Data Stream data2

Momentary estimate of when default is most likely to occur

Second, the chart also shows the market’s expectation of how the default probability rises over time. Here one fixes the signing date for CDS on bonds of various maturities and examines the probability differences between, say, one-year debt and two-year debt, by following issuance-date lines from southeast to northwest. This lets us see whether the markets expect some sort of peak in default probability in the future.

The chart clearly shows:

  • As of the beginning of the year, the perceived short-term riskiness of Italian sovereign debt quadrupled, rising much more at shorter than at the longer horizons.

This suggests that markets believe that the big default risk is in the next couple of years, but if Italy gets through these years, the likelihood of a default declines sharply.

  • The figure also shows that the most recent risk profile – comparing the profile of issuances in October versus November 2011 – shows a ‘hump’; default probabilities first increase (for maturities of up to two years) but then decrease (conditional on no default occurring until 2013).

What this means is that markets are pricing in a heightening of risk two years from now – mostly probably due to political tensions and the risk of deadlocked reform.
In other words, financial markets are betting that it will take Prime Minister Monti at least two years to get past the “harsh times”. The key question is: Will Berlusconi listen to the markets and give the new government enough time to get over the hump?

1 This assumed amount is akin to pay-out in a life insurance policy; it must be assumed since the size of the bond holder lose is never clear in advance. For example, in the Greek case, bond holders were at first asked to take a 20% hit, and then asked to take a 50% hit. 40% is a mid-field estimate of losses for past sovereign debt defaults.

2 The figure shows the conditional default probability on a contract negotiated at time t with maturity T, p(t, T): This is the probability that a default will occur between time t and t+T, conditional on not having occurred before time t+T. In the figure, the vertical axis shows the probability p(t, T); the "time" axis on the right shows the date when the contract was negotiated, t; the "maturities" axis shows the maturity T.


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