Europe default risk signal flashing red

September 16, 2011: 3:45 PM ET
The risk of sovereign default in Europe is increasing

The risk of sovereign default in Europe is increasing.

NEW YORK (CNNMoney) -- Europe default risks are on the rise. Take one look at the market for credit default swaps, and the probability that Greece will default on its $345 billion in debt is near 100%. Portugal, Ireland, Spain and Italy aren't too far behind.

Credit default swaps, or CDSs, are essentially insurance contracts that give bondholders a way to get paid back if a country or a company stops making interest payments on its debt. The data are useful in gauging how worried investors are about potential defaults.

Some investors buy these swaps as contracts on bonds they've previously purchased. Other investors, like hedge funds, simply buy the insurance but not the bonds.

"Credit default swaps are basically a thermometer of the market's perception of someone's creditworthiness," says Peter Boockvar, the equity strategist at Miller Tabak + Co. "We're obviously seeing legitimate concerns from the market that these countries will have difficulty paying back what's owed."

For nearly half the countries in the European Union, the price of insuring sovereign debt has increased more than 100% since July 2010.

In Greece, credit default swaps have become prohibitively expensive. The sellers of these swaps, or contracts, are currently demanding that buyers pay $6 million up front to protect $10 million worth of Greek bonds, according to data from Markit.

"This implies that there's a 100% chance of default," said Anthony Sanders, a professor of finance at George Mason University.

Europe's debt crisis: 5 things you need to know

A typical credit default swap functions more like Portugal's swaps. Sellers of Portuguese CDSs currently demand that a buyer pay $1.13 million per year for 5 years worth of insurance on $10 million in bonds.

In July 2010, buyers would've paid just $284,000 per year for the same contract. For Ireland, Italy and Spain, the annual costs are now $918,000, $508,000 and $425,000 respectively.

After Greece, investors bet that Portugal would be the next member of the European Union to fall, with a default probability of 66%. For Ireland, that figure slips to 51%; the chances of Spain and Italy defaulting are 33% and 28% respectively, according to Markit.

These probabilities are calculated based on the current cost of buying protection over a period of years, typically five, versus the expected recovery rate.

According to several traders, the market generally assumes that if a country defaults, bondholders will receive roughly 40% of the value of the bonds. Still, that number is somewhat speculative because there hasn't been a sovereign default in nearly a decade. The most recent example, Argentina, defaulted in 2002.

Of the European Union member nations, only buyers of Greek credit default swaps are forced to pay an upfront fee. But few of these deals are getting done, according to traders.

On top of that, if Greece were to default, those who hold $10 million worth of Greek bonds, wouldn't get that full amount back. Instead, they would get the difference between what Greece's creditors receive during a restructuring and that $10 million. Assuming a '40 cents on the dollar' scenario, that would work out to $6 million.

Every single country in the European Union with the exception of Latvia has seen the price of insuring its debt rise in the past year. Outside of the so-called PIIGS (Portugal, Ireland, Italy, Greece and Spain) or peripheral European Union countries, Denmark, Finland and Slovenia have seen the most drastic jumps in the cost of protection.

"The costs are skyrocketing. These numbers tell us that the markets are getting prepared for the shockwave that will hit Europe," said George Mason University's Sanders.

Michael Cirami, a portfolio manager at Eaton Vance, presciently purchased 10- and 15-year swaps on Greek debt in 2005 and 2006 for roughly $20,000 in annual costs. Cirami's fund sold them at a steep premium.

The next big play for Cirami: "We're basically concerned about Spain and France. We think there are big concerns and the spreads don't adequately reflect the risk in those countries," he said.  To top of page

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