Could 'weapons of mass destruction' still hurt Ireland's future stability?
Published 18/03/2010 | 05:00
AS Greece struggles to avoid defaulting on its debts, the question is whether Ireland could face a similar fate. Faced with a spiralling debt and profligate public spending in the past, Ireland appears to have many of the same problems that brought Greece to its knees.
At the heart of Greece's problems is the financial instrument called a Credit Default Swap (CDS).
Outside of the finance industry, however, few understand exactly what a CDS is. The CDS is a derivative, instruments that Warren Buffett once famously called "weapons of mass destruction''.
A credit default swap is essentially a form of insurance against a company defaulting on its bonds. For example, an investor may hold $10m worth of 10-year bonds for Company A. If Company A goes bust, then the $10m is lost. However, a CDS allows an investor to hedge their position.
An investor may buy a 10-year CDS covering Company A at $10,000 per year. Therefore the maximum an investor will lose over the 10 years is the $100,000 he will pay in annual premiums.
In return, the CDS guarantees that if, at any point over the 10 years, Company A goes bust, then the investor can claim the $10m from the firm that sold him the CDS.
Credit default swaps are used for government bonds as well as corporate bonds.
In theory, a credit default swap makes a lot of sense. If the market thinks a company is likely to default, the price of its CDS goes up. If the market thinks the company is stable, then the price of its CDS should be lower.
The bond should drive the price of the CDS. In practice though, CDSs can be used to drive the price of a bond.
According to Greek Prime Minister George Papandreou, speculation through CDSs has played a key role in his country's problems. This has been denied by market professionals.
Nevertheless, France and Germany last week called for tighter controls on CDS trading.
So could Ireland face a similar problem in the near future? Philip Gisdakis, head of Credit Strategy and Structured Credit at the German bank Unicredit, thinks not.
"The Irish Government reacted much sooner than the Greeks to their challenges and adjusted fiscal spending.
"That is why I think the risk that Ireland will face another wave of spread widening is not very high," he said.
Any EU or IMF bailout of Greece may calm the markets and also reduce pressure on Ireland.