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.
