CDS Prices Due for Sharp Adjustment Today

It is not clear what signal Federal Reserve Chairman Ben Bernanke intended to send out to the capital markets when he highlighted "the very serious too-big-to-fail problem" in a speech at the Economic Club of New York yesterday. But there is no mistaking the signal for pricing specialists in the $60 trillion credit default swap market. In the briefest of terms, the status of the too-big-to-fail syndrome and the latest recession-related data point to widening spreads, starting today, in both investment grade and non-investment grade CDX and iTraxx indexes.

Given that many credit default swap traders were, until Wednesday, working on the assumption that the bailout (or rescue) packages, in their totality, in America and Europe have resulted in a high level of governmental re-insurance of residual counterparty risk, spreads on the key indexes (e.g. CDX IG-11) had begun to narrow. But the Fed Chairman's comments are now causing market participants to reconsider the virtue of the implied last-resort default coverage by the world's central banks.

Compounding the pricing challenge is the fact that central banks did, perhaps unintentionally, become significant contributors to artificial spreads in the early part of this week. The Fed's activity in the commercial paper market, for example, is helping some of America's biggest corporations to retain superior credit ratings by effectively rewarding maturity mismatches, i.e. agreeing to finance long-term assets (the cash generating potential which may well be in doubt) by cheap short-term loans: as example, a rate of 2.10% from an earlier 3.85% for General Electric's (GE) financing arm, and from 4.6% for Citigroup (C) (Bloomberg October 15, 2008).

Without the Federal Reserve, the credit rating of both GE and Citigroup would be in question and, as a consequence, spreads for credit default swaps on both risks would widen considerably, in anticipation of margin compliance demands. Besides, in the absence of easy access to short-term funds, rating downgrades for both GE and Citigroup would certainly become a reality. In that event, downgrades would, in turn, trigger cash margin calls on default insurance providers (e.g. AIG), and Ben Bernanke would be confronting a number of too-big-to-fail scenarios.

The pricing of credit default swaps is conditioned by a two-pronged analysis: the risk of deterioration in the business model of the issuer of the reference instrument and the counterparty risks emanating from the entities contracting the swaps. It has now become common practice to rely on the rating agencies to establish the framework for the requisite analysis. On closer scrutiny, however, it is evident that rating methodologies currently in use do not provide any guidance whatsoever for pricing default insurance. Such methodologies have often proven inadequate even for the relatively inferior task of pricing spreads over treasuries in the face of the real prospects of a prolonged and severe recession in America and elsewhere.

The principles upon which any bond insurance is priced bear no relationship to the principles which drive risk-neutral quotes for debt or standard parameters defining traditional hedge contracts like interest rate swaps and far-forward currency deals.

On Wednesday, the CDX North American investment grade index (IG-11) was being quoted at 185-195 basis points; at one point last week, the spread had widened to 215-225. Is a rapid move towards 300+ basis points and beyond inevitable? The answer rests in the response to three fundamental questions:

Are the current spreads based on the dubious assumption that, in one form or another, the US and Canadian governments will continue to extend lifelines to major corporations? Do the spreads include the impact of recessionary conditions on corporations which constitute the index? And, finally, do the spreads, as a general rule, sufficiently capture the heightened risks of mid-stream credit events (cash calls)? For guidance, the iTraxx investment grade index moved out 50 basis points to 315.

The picture for the high-yield segment of the CDX and iTraxx indexes was even more dismal as trading in the credit default swap market for inferior credits came to a virtual standstill on Thursday. The iTraxx Asia ex-Japan index was being quoted at a record bid-ask gap of 850-1050 basis points. (Reuters October 16, 2008).

Comments

[CreditTrader:]

Few points worthy of discussion -
1) None (that is zero) of the nine entities that the US injected capital into on Monday are a part of the CDX or iTraxx indices, so be careful about broad index-related comment based on the positive/negative views of these financials.
2) We did see spread decompression in these names (or at least the seven that trade) in the 5Y but <3Y (which is the guarantee's maturity) compressed significantly and curves steepened considerably.
3) Historically, IG spreads must be around 140bps to cover investors for 'actual' realized losses through a 'normal' recessionary period. With IG around 200 in the US, we are clearly seeing a more prolonged and severe recessionary period with far higher defaults being priced in.
4) We would expect corporates to see some unthawing of the primary IG new issue markets as traditional managers can once again (in the absence of short-term default risk) buy the new issues and then buy protection from their favorite (guaranteed) broker to cover any concerns over credit quality. Given the concessions, this is likely to start soon (e.g. IBM's bonds went out well over 120bps cheap to CDS).

Hope this provides a little more color

2008 Oct 16 01:24 PM

[whidbey:]

Profound questions with few answers.

We do know there have been certain "assumptions of support" that are probably unwarranted if for no other reason than government fears have been palpable and maybe easily played upon.

The pricing of credit in all forms has never had to reflect risk efficiently; doing so is an "art" not a science. What your comments suggests is that several of our industrial firms will have problems if risk across the board is priced realistically. I hope not, it is a whole new level of fear to live with.

2008 Oct 16 02:09 PM

[dkp:]

I think what we have found is that people selling credt protection have themselves very little credit worthiness, and ultimately they are relying on the govt bailouts. I cannot understand why investors are buying securities in which they have no confidence, and then rush to buy credit cover.

CDS market is pure speculation and must be banned as a market.

2008 Oct 17 08:58 AM