CDS Market: Don't Believe What You See

The cost of credit default insurance on US Treasuries surged to 42.5 basis points Friday. For perspective, the cost was at 1.6 basis points in July of 2007. If you believed that the CDS market was correctly pricing the risk of the United States government’s creditworthiness, you would conclude that the United States government is now 27 times likelier to default on its loans than it was a year ago.

There is another explanation, though, which is that the CDS market is simply imploding. If so, the price of credit default swaps has less to do with the creditworthiness of the underlying debt, and more to do with the fact that the cost of writing these contracts has just gone through the roof.

Why? Four reasons. First, CDS will soon be regulated by the CFTC, which increases compliance costs dramatically. So more basis points, if you please. Second, the price for equity put options is just astronomical these days. Ordinarily, if a trader couldn’t get a nice deal on some puts, you could switch into CDS as a surrogate trade. So put options get pricey, CDS gets pricey too. And it doesn’t help matters when the price of equities is dropping. What we’re seeing a feedback loop here. CDS goes up, stock prices go down, put option pricing goes up, and CDS goes up higher still. Third (and maybe most important), the cost of borrowing stocks to short has gone through the roof. This has to do with all sorts of things – risk aversion being chief among them.

More fundamentally, it used to be possible to do naked shorting, which kept the price of borrowing equities pretty low. Now that naked shorting isn’t available, the price of borrowing equities to short is higher than ever. In a nutshell, the CDS market is shooting up higher because the price of alternative bearish plays is sky high, caused (in large part) by new restrictions on short sales and fueled by the collapse of the equities markets around the planet. Higher spreads on CDS don’t have as much to do with credit-worthiness of the underlying debt as you might guess.

Bottom line for investors is this: if credit default spreads don’t have to do with creditworthiness of the underlying debt, then the risk of certain assets in the marketplace has been priced too high. We see evidence of this incorrect risk pricing in theoretically impossible scenarios, such as negative yields on short term Treasuries, that are popping up here and there, leaving traders scratching their heads and drawing dire conclusions. A trader’s faith in the accuracy of the markets as a pricing mechanism is so great, they do not consider the mechanics of why derivatives prices move as they do (ironically, clamping down on short selling has produced the most violent global bear market in history).

Moreover, why argue with the tape, when the trend is your friend? And how “incorrectly” is risk pricing at the moment? Take domestic equities as an example. Assuming a 25% collapse in corporate earnings (something on the order of a Great Depression scenario), we still have an earnings yield of about 7% on the Dow Jones as of the close of market Friday, compared with a 3.2% yield on a ten year US Treasury.

Even assuming the yield on a ten year Treasury soars to 4%, the risk premium on the Dow Jones is almost 100% higher than where it “should” be. What’s the bottom line on what an investor should do? That depends on whether you think the capital markets will catch on to what’s actually fueling the apparent decline in creditworthiness of not only the US government, but most other governments in developed and emerging markets, and most foreign and domestic companies as well. It will, folks.

Listen, the creditworthiness of nearly all debtors on the planet isn’t dropping 270% a year, the price of bearish trades (including credit default swaps) is spiraling up. In a sense, the explosion in the price of CDS (and VIX options, puts, borrowing equities short) is getting to a point where you could call it a “bubble” in bearish trades. As with any bubble, there is rampant speculation that “its different this time”, “we are in a new era of wealth destruction that will not end” and “value does not matter”. And bears are trading with such conviction, they’ll pay whatever it takes to go short on anything. My neighbor, a dentist, recently bought a bunch of short ETFs – and was telling me with ebullient satisfaction about how much he’s made off them already. Well, eventually, capital markets sniff out all bubbles, once people figure out what trading mechanics are driving it. Like all others before it, this “bearish trading” bubble will pop violently. And when it does, the ensuing bull market will be stunning.

Comments

[Tom Armistead:]

A bublle in bearish trades...I think you're right.

2008 Nov 23 12:54 PM

[John Ryskamp:]

Yes, unless corporate earnings drop far more than you are predicting. Stay tuned!

2008 Nov 23 01:00 PM

[Kevin Walmsley:]

The author ignores the primary reason for the spike in premium pricing: the fact that so many of the players in the CDS markets are no longer in business. As the number of available counterparties falls, they will demand higher premiums. After all, there are limits to THEIR capital; obviously they will take the trades on which profitability is highest, and risk is lowest. And when Bear Stearns, AIG, and Lehman out of the game, and every finance company on earth hoarding capital and reducing exposure, premiums have only one way to go. Up.

2008 Nov 23 01:38 PM

[happysoul77777:]

A very well-written article!

Investors should not trust the CDS spread. The other day, the CDS priced Berkshire with a junk rating. And the ideat that US government is going to default on its loan is absurd! The US government is going to tax everybody tp death first, before it defaults on its loans!

2008 Nov 23 02:36 PM

[AlexR:]

Thanks for the brilliant, insightful article. I'll add some of my own thoughts:

For the first time in history, "short-selling for dummies" is available in the form of easy-to-understand and easy-to-trade inverse return ETFs. For the first time, you can now short-sell in an IRA, because of these ETFs. For the first time, large masses of uninformed investors will be able to short-sell without first going through the "eye-opening" margin account application process with all the scary disclaimers. For the first time, retail investors can go short without the terrifying risk of "unlimited" losses. And for the first time, novice investors will be able to go short without having to have someone explain to them many times over, how short-selling works.

Remember how many people jumped into the QQQ's after it had gone up 100% the preceding year?

Here is a doomsday prediction exercise. In early 2009, large masses of investors will finally decide to open their year-end brokerage statements. Those who decide to stay on the market will be thinking more seriously about asset allocation. Some will notice the stellar past performance and "low correlation characteristics" of inverse ETFs, and will decide to allocate a chunk of their assets there. Inverse ETFs will receive record capital inflows, leading to short-selling in an unprecedented scale. The market will continue to drift lower for months. People who are not short the market will feel stupid and left out. The "bear bubble" will continue to inflate until the remaining skeptics jump in, leading to a final climax run. Counterparty risk will cause some inverse ETFs to start trading at a discount to NAV. The climax run will be followed by a sharp reversal. In the middle of this one-two volatility punch, at least one counterparty will fail, causing massive unexpected losses. After millions of investors have lost money, the SEC will finally step in and create new restrictions on short-selling, including, banning the purchase of inverse ETFs in IRAs and other non-margin accounts, or maybe even banning them outright.

2008 Nov 23 03:44 PM

[grouphero:]

All ups and downs do not occur naturally, it is orchestrated by somebody or group of somebody for a certain objective. The result has to be unexpected or extreme (used to call "bubble") otherwise the ordinary guy will be able to beat and profit from them. Usually such extreme cannot last long as the longer it is, the more danger it is for those somebody. They cannot allow the ordinary guy to sell out high before the crash and they cannot allow the ordinary guy to buy cheaper than them. With so much cash sitting on the sidelines, there will be no panic on the sell side as seen by the light volume. This will be a tug of war and those somebody will be in a difficult position to win big this time as there are less ordinary guy or these guys are financially stronger to weather the negative trend than expected. The news will have to be manipulated carefully so as not to let the market get out of control but there may be less and less bad news as time went by longer. With the advance of internet, the ordinary guy can study and learn a lot more than expected and the level of panic is substantially lower and with so many historical analysis in the market right now, the trend is quite clear that things will turn better in a much shorter period of time, say 6 - 9 months. This may pose a danger to those mastermind who put so many resources to manipulate the market but cannot get the return expected. In fact, it may be time to cut a little meat from the elephant.

2008 Nov 23 04:35 PM

[Moon Kil Woong:]

Welcome to unintended consequences. When will government learn to let markets operate on their own save regulating banks and financial institutions. Preventing shorting means you can't hedge which means that the market is too risky. That means, I'm out of stock and so are hedge funds and any other smart investor. LOL to supporting the market by destroying market mechanisms.

2008 Nov 23 11:16 PM

[John Lounsbury:]

AlexR - - -

I gave your comment a "thumbs up" rating but do not think we will reach doomsday. In order for the scenario to play out as you suggest, we must have such a severe recession (or depression) that corporate earnings drop far more than any projections I have seen, resulting in stocks dropping near zero. (I would consider a 90% drop from the October 2007 highs to be near zero, more than the 89% market drop from 1929 to 1932.) Failing that very unlikely scenario, valuation levels will become so compelling that a surge in buying will produce a rally with a massive ensuing short squeeze. Passive short ETF buyers will be punished and cured of overcommitting to those vehicles. They will then return to their intended purpose: active trading and hedging.

This playout of events is similar to yours, but I do not see the devastating collapse you fear. I expect the scenario to unfold over the next year with the ultimate market bottom for this cycle to be within the range of the current low (752 S&P 500, Nov. 20) and the next support level of 680 (early 1996 top). Government regulatory intervention will be unlikely.

A break (S&P 500 closing price) below 680, would cause me to re-evaluate your doomsday scenario, because I see the next technical support level at 482 (early 1994 top). This would be a distressing decline of nearly 70% from the October, 2007 top.

Looking at fundamentals, I must admit that PE ratios below 10 for the S&P 500 (using current earnings estimates from Standard & Poors) would require a drop below 500 for the index. However, if interest rates remain low, we may not reach such low PE ratios. In the 1970's we reached single digit PE values with much higher interest rates. Fair value earnings yield (the inverse of PE) are lower when the risk free return (U.S. treasuries' yield) is low.

2008 Nov 28 01:29 PM