Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Wednesday, 16 May 2012

Eurozone: The train allegory revisited


This is something I wrote almost a year back (27-May-11) in my earlier avatar as Sovereign CDS trader at a local bank.

On a foggy day a train is heading towards a bridge on a river. Gazing out through the fog some of the passengers notice the bridge broken. A few of them try to alert the guard and train staff to the danger but their concerns are brushed aside. "I assure you gentlemen, the bridge was built by some of the finest engineers in the world" says the guard. "In fact my brother was incharge of the building project and he has top grades from the best schools". This satisfies most of them and they return to their seats confident in the ability of the engineers. "After all the guard is the expert and must know better" they reason as they dismiss what they saw as an optical illusion. The persistent ones who still harangue the guard are warned sternly not to create panic and disturb other passengers otherwise they will be ejected from the train at the next stop. The smarter ones realise the futility and prepare to jump out at the earliest opportunity. Indeed some waste no time in doing so. They reason that risking injury is better than certain death. The remaining try and pull the emergency alarm but it doesn't work. Then they attempt to wrest control from the driver and run towards the engine, pursued by the guard and staff. Their shouts warning the passengers about the danger ahead are countered by the staff shouting about the impossibility of it. The PR system plays a tape about the unblemished safety record of the railway company. Some of the passengers are injured by the crowd of people running through them and all are confused by the conflicting statements. Most realise something is wrong but don't know what to do about it. All the while, the train is chugging along.

It seems that the train has reached the bridge. The only thing that remains to be seen is how many bogeys fall into the river.

It is interesting to compare CDS levels prevailing at that time when there were more than a few people insistent on selling protection and buying bonds.

Country
5Y CDS
(27-May-11 close)
(bps)
Current 5Y CDS (16-May-2012)
(bps)
% change in spread
Portugal
685
1121
64%
Italy
165
513
211%
Ireland
675
663
-2%
Greece
1455
Defaulted
--
Spain
257
545
112%
iTraxx® SovX index
201
301bps (excludes Greece)
Not comparable
France
75
222
196%

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