Great news from Greece: its brand-new €5 billion, 10-year bond issue was three times oversubscribed and is already rising in the secondary market, after pricing at a spread of 300bp over the mid-swap rate. Greece is paying a 6.4% yield on the issue, which is pretty affordable in the grand scheme of things, given how much trouble it’s in right now. And now that this bond has gone so well, there will surely be appetite in the market for more where that came from.

One of the big problems with debt markets is that, especially during times of stress, they become very illiquid. Many bankers have spent many hours trying to explain to emerging-market finance ministers that just because their bonds are trading at a certain level in the secondary market, that doesn’t mean they can issue new bonds at that level, or even at all.

But it turns out that a liquid CDS market is a great way of enabling countries to access the primary markets even when the secondary markets are full of uncertainty and turmoil. Which is yet another reason to laud the notorious buyers of naked CDS protection, rather than demonizing them.

This isn’t the first time that George Soros has wheeled out this particular argument against credit default swaps:

The situation is aggravated by the market in credit default swaps, which is biased in favor of those who speculate on failure. Being long CDS, the risk automatically declines if they are wrong. This is the exact opposite of short-selling in equity markets, where being wrong means that the risk automatically increases.

It’s worth explaining this in a bit more detail. If you short a stock, the amount of money you can lose is theoretically unlimited. It costs you little or nothing up front, but as the losses move against you, not only do you start getting hit by margin calls, but also the realistic total downside is increasing at the same time.

For instance, let’s say you short a stock at $100, and you know that there’s a 20% chance that the stock will rise by 20%, reaching $120 per share. When that happens, you’ve lost $20 — but now there’s a 20% chance that the stock will rise by another 20%, to $144. And if it gets there, there’s a good chance that it will continue to keep on rising. No matter how high the stock goes, your downside — the amount of money you can realistically expect to lose — continues to grow.

On the other hand, let’s say you spend $100 to insure $1,000 of bonds against default — without owning the underlying bonds. And let’s say that the price of the bonds rise, and their yield falls, as worries about their creditworthiness dissipate. Then the CDS you just bought for $100 might now be worth just $80: again, you’ve lost $20. But now your downside is smaller than it used to be: in the absolute worst-case scenario, you can only lose $80, while initially the worst-case scenario was that you could lose $100.

Financial professionals like Soros tend to mark their positions to market daily — if the market moves against them, then they consider themselves to have lost money, even if they don’t exit the position. And Soros is quite right that when they do decide to hold on to their position, a short stock position which has moved against you looks riskier than a long-protection CDS position which has moved against you.

But buying CDS protection is not really equivalent to shorting a stock — it’s much closer to buying a put option on a stock. And if you do that, your risk diminishes as the market moves against you, just like it does with CDS: you can never lose more money than you initially spent on entering the position. But it’s entirely commonplace for investors to short stocks by buying puts rather than by borrowing and selling securities. Similarly, there is a developed repo market in bonds, so anybody who wants to short a bond the old-fashioned way, by borrowing it and selling it, is welcome to do so. In that case, the risk profile falls somewhere in the middle: there is a limit to how much a bond can rise in price, since the yield will never fall much below zero, and the price is very unlikely to exceed the total value of all principal and coupon payments.

Ultimately, Soros’s argument here is pretty weak. Every CDS contract has a buyer and a seller, and in general it’s the seller of protection who ends up making money: the buyer of protection is often just hedging an existing position, and not looking to profit on the short leg of the trade. Buying credit default swaps is quite an expensive thing to do, and it’s hard to make money at it except for in times of chaos or crisis. If the market in CDS was really biased in favor of those who buy protection, then credit default swaps would be an asset class in their own right, and people would buy bundles of them in the hope of making money. But that doesn’t happen — and Greece, for one, has many bigger problems on its hands to worry about what might be going on in the market for Greek CDS.

Is there any sovereign credit which looks remotely attractive these days? I feel like a bit of a heel talking about fiscal distress even as the attention of the world is rightly concentrated on much more pressing real distress in Haiti. But the drumbeat is getting hard to ignore.

Alex Dalmady has a good overview of Venezuelan debt, which has been soaring of late and which might yet continue to go up. If you’re a short-term momentum trader, it looks great. But buy-and-hold types have no business being in Venezuela:

Buying Venezuelan debt is like lending money to a wealthy, eccentric and partly insane uncle. You kind of figure he’s good for it, but there’s a good chance he’ll blow his fortune buying real estate on the moon or something and leave you hanging out to dry…

Corruption, deliberate misinformation and ineptness merge together to form an incomprehensible mess. There isn’t an official figure that can be trusted… the Central Bank puts FX reserves at $35 billion. Really?…

Alex concludes that while the opportunity cost of not being invested in Venezuelan debt is hight, a crunch of some description is “inevitable”. And therefore he just avoids the country altogether, which makes sense to me.

He should probably avoid Argentina too, while he’s at it. The debt situation there has never been messier: the president wants the central bank to transfer $6.6 billion into an account ring-fenced for paying private creditors. When the central bank governor refused, he was fired by the president, reinstated by an Argentine judge, and then seemingly confirmed in his decision by a US judge, who has frozen the central bank’s account in New York.

Right now the account only has $1.7 million in it, but as Goldman Sachs analyst Alberto Ramos says in a research note today, “the political and institutional implications of this preliminary court order could potentially be large and eventually lead the government to back off from insisting of getting the $6.6 billion from the central bank”. After all, if the $1.7 million is subject to attachment by holdout creditors, they’ll probably be able to go after any disbursements from the $6.6 billion fund as well.

The Argentine economy minister is still adamant that the country’s bond exchange is going ahead as scheduled, but there’s no way that’s actually going to happen if a puppet is in charge of the central bank or if there’s serious doubt about the ability of the government to get the contents of the $6.6 billion fund to bondholders without the money getting hijacked along the way. Certainly the bond market doesn’t think much of the Argentine credit these days.

Meanwhile, Greek debt is looking increasingly shaky, as Moody’s talks about the country suffering a “slow death” and Desmond Lachman says that Greek might as well leave the euro zone now, since it’s going to have to do so sooner or later in any case, and the longer it waits the more painful the process will be. Further east still, Barclays is reckoning that Nakheel debt in Dubai will ultimately recover less than half its face value. And of course other sovereign nations are having major problems too, from Iceland to the Pequot nation of Mashantucket.

This time last year, Paul Kedrosky and I wondered if 2009 was going to be the year of sovereign defaults. It wasn’t, and things look better now than they did back then: the number of countries with EMBI spreads of more than 1,000bp over Treasuries has gone from 14 to just one (Belize). That move, however, has happened without any real improvement in sovereign fundamentals. As a result, I fear that the main thing the rally has achieved is just to increase the downside of a sovereign-debt crisis, and minimize the upside should the world manage somehow to muddle through.

(HT: Otto)

If you think that the Dubai situation has pretty much been resolved with that cash infusion from Abu Dhabi, think again. Paul Whitfield and Vipal Monga explain that nothing really has been cleared up at all, and that there are far more — and far bigger — uncertainties surrounding the emirate’s finances than most of us had suspected.

For one thing, Dubai has no real legal structure capable of dealing with a default on this level, which has forced it to hurriedly import a jury-rigged system with UK and Singaporean jurists, based on British and American (not Islamic) legal structures.

But it’s not clear how trustworthy the Dubai’s government — its ruling family — really is, given that they actively encouraged the idea that Dubai World had a sovereign guarantee.

And it’s also far from clear what has happened to the $10 billion received from Abu Dhabi in February, or, for that matter, another $5 billion that was lent to Dubai by two Abu Dhabi banks in November. As for the further $10 billion which arrived in December, we know that $4.1 billion of it was used to repay Dubai World’s sukuk. But the final destination of the remainder of the money is also opaque.

What’s more, no one has much of a handle on the total liabilities involved, either:

Dubai World has officially released a $59.3 billion debt figure as of the end of 2008, but that number isn’t taken at face value by financial experts.

Deutsche Bank AG, for example, says that the figure included more than just financial debt, including equity, and payments due to suppliers. Discounting the nonfinancial debt led the German bank to estimate Dubai World’s financial external debt at $24.27 billion.

Morgan Stanley has its own estimate of the liabilities, taking a disclosed $26.2 billion number from Dubai and then adding another 30% to that to account for a presumed undisclosed amount, putting Dubai World’s debt at a seemingly arbitrary $34.1 billion.

The upshot is that the restructuring is going to be messy and unpredictable: my guess is that it’ll be a highly political process which will drag on for years. As ever, the big winners are certain to be the lawyers.

Peter Applebome notes that dire financial situation at Foxwoods casino looks much more like a sovereign default than a run-of-the-mill commercial real-estate deal gone sour:

The Pequots, like all Indian gambling operators, are no mere business enterprise but a sovereign nation, exempt from most commercial regulations and almost certainly unable to use the bankruptcy laws or sell off gambling assets that could be operated by others. So lenders have no choice but to restructure debts, work with the tribe and hope that the economy picks up.

Essentially, the lenders can’t foreclose on the casino, because the current owners — the Pequots — are the only people who can own it. If it’s not an Indian casino, it’s can’t be a casino at all. That, in turn, gives the debtors enormous leverage over their creditors: they can pretty much name their terms, and the lenders have little choice but to agree to them.

How did the lenders find themselves in such a dire situation? I think you know the answer to that one: they just weren’t thinking.

“It’s kind of uncharted territory,” said Tom Foley, a lawyer who specializes in Indian gambling issues and is a past chairman of the National Indian Gaming Commission. “Many of the banks and bondholders should have been aware of these kind of risk factors, but when everything is good, nobody is really looking at the downsides.”

You can be sure they’re looking at the downside right now.

Sudip Roy has gone me one further today. I pointed out the contrast between the expected actions of Sheikh Mohammed bin Rashid al-Maktoum in Dubai, on the one hand, with those of normal homeowners in the US, on the other: while American individuals are ceaselessly told that they have a moral obligation to pay their debts, the ruling family in Dubai is simply defaulting on its non-recourse underwater loans in accordance with the amoral principles of capitalism.

Sudip, however, goes so far as to say that Dubai is morally obliged to reject a possible sovereign bailout. I’m not sure where he finds this moral obligation, especially since Dubai is not a democracy and its treasury has no fiduciary duty to the citizenry as a whole. But I can see where he’s coming from: there is something morally dubious about throwing good money after bad, given all the other things that any of us, be we citizen or ruler or corporate entity, can do with our cash.

In general, a government has the right — but emphatically not the obligation — to bail out absolutely any company it wants, anywhere in the world. Some such companies carry an implicit government guarantee, even in the face of explicit denials that such a guarantee exists — that was the case with Fannie and Freddie. Some companies (Citigroup, AIG) are considered too big to fail, and the implicit government guarantee is replaced by a very similar moral-hazard play. Other companies are just so politically important that government ultimately steps up with a bailout: think GM and Chrysler. But it’s crucial that all such determinations are made on a case-by-case basis, and that the government at least retains the option to say no to a bailout in each case.

That’s why I was happy that Dubai left Dubai World to sink: defaults at state-owned companies are rare things, and we need a few more of them to underline the fact that such companies are not, just by dint of being state-owned, vastly more likely to get bailed out than anybody else.

Sudip talks about the precedent of Naftogaz in the Ukraine, where the government negotiated a restructuring where creditors took a haircut in return for a sovereign guarantee on the remaining debt. (How much a Ukrainian sovereign guarantee is worth, of course, is another matter entirely.)

But it’s also worth remembering in this context that even when there is an explicit sovereign guarantee, it’s to all intents and purposes unenforceable in the event of default. Sovereigns are, by definition, sovereign, and it’s very, very difficult to sue them — which is one reason why some creditors end up settling for three cents on the dollar. Even if Dubai World did have a sovereign guarantee, the Dubai government could still have let it go into default, while remaining current on all other debt — and there’s almost nothing that Dubai World’s creditors could do about it.

This financial crisis has been one of commercial debt rather than sovereign debt, but there have been sovereign debt crises in the past and there will be more in the future. So anybody thinking that a sovereign-debt play constitutes some kind of flight to quality would be well advised to think again. Sovereigns can and will do whatever they like, including defaulting on state-guaranteed obligations. And they’re prettymuch the hardest entities in the world to sue if you want to attempt a legal strategy for getting your money back.

Update: John Carney adds that “guarantees on debt are prohibited by the shariah” — maybe that’s the moral obligation that Sudip is referring to.

The Dubai World default is big news — big enough that it’s even made it into Gawker. Your one-stop shop for bloggy coverage this Thanksgiving is Alphaville, which features for instance this wonderful chart of the debt structure which is now being crawled over by lawyers around the world.

Personally, I’m quite happy about this default, since it sets another very useful precedent of a state-owned company defaulting on its debt. Historically investors in state-owned companies have perceived an implicit sovereign guarantee — there’s even a German word for it, Anstaltslast. The result is a huge and unhelpful moral-hazard trade.

So it’s great that the government of Dubai has made it clear that Dubai World’s lenders aren’t going to be automatically bailed out by the sovereign, despite the fact that the government has hundreds of billions of dollars in its sovereign wealth fund*. Would that Treasury will follow suit when it comes to the creditors of state-owned companies like AIG.

*Update: As my commenters have pointed out, it’s Abu Dhabi which has hundreds of billions of dollars in its sovereign wealth fund, not Dubai. Some of those dollars might well yet be used fora Dubai bailout, but it won’t be on terms Dubai likes.