The rally in CDS prices is believed to have been largely the result of short-covering by hedge funds; there was very little, if any, fresh capital committed to new long positions. Those exposed to the eurozone crisis have simply been hedging their bets. Secondly, by the morning of October 12, no new eurozone agreement on the EFSF was yet in place. While Slovakia has since stopped dragging its heels and now fallen in line to approve the EFSF expansion, that particular wrangle provides a fine example in microcosm of the difficulties encountered when trying to get 17 countries to agree to anything.
Much now depends on the outcome of this week’s second European Union summit meeting to determine measures to deal with the Greek bailout, possible bank recapitalisations, and the shape of the bailout tools. Credit market specialists had expected CDS prices to hover at their recent levels in the run-up to the summit, but there is a serious risk of an imminent sell-off if the meeting fails to deliver. This is, after all, what has happened before. “As soon as the pressure is off, everyone goes back to siesta time”, commented a senior credit analyst in London.
Much more complicated and even more potentially controversial is what role the newly enlarged EFSF will have. There seem to be three main options: for the EFSF to function simply as an issuer of bonds, though with enlarged capacity, and then a lender; for it to enlarge its borrowing capacity still further through leverage and become, in effect, a super hedge fund; or for the EFSF to become a guarantor of dodgy sovereign debt, like a giant monoline insurer.
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