Credit Default Swaps: Is Low Supply Lifting All Boats?

So in looking at CDS pricing across the board lately one could assume that systemic risks have risen just about everywhere.  However, spending a little time looking at the SOVR screen in Bloomberg, which offers both currency pricing and 5-year credit default swap pricing on sovereign debt, I began to wonder if the CDS market is still as efficient as it use to be.

I have no doubt that the credit quality of national issuers has been under pressure with the size and scope of the regional bank bailouts underway.  Rating agencies are of course talking of downgrading entire countries.  That said, seeing that CDS prices on US, Japanese or UK debt have risen over ten fold since 2007 has made me wonder if the probability of default by the largest economies is ten times higher, or if maybe it’s only five or seven times higher (arbitrary) and that maybe the balance is due to the fact that there are now less underwriters of the loosely regulated OTC derivatives market.

Between Lehman’ collapse, AIG’s paralysis and effective collapse, shrinking hedge funds, and other counterparties, it occurred to me that a portion of the price inflation for credit protection may be attributable to supply constraints.

I would love to see some buonafide research on this.  If anyone knows of any, please let me know.

Bloomberg SOVR Screen 2.20.09

Bloomberg SOVR Screen 2.20.09

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