Panic in CDS Market to Cause Next Collapse in Equities 19 comments
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The Markit iTraxx Crossover index, composed of 50 non-investment grade European corporations, has breached 1,000 basis points today, suggesting that a record number of European companies are on the verge of default due to deepening financial problems. This index was trading at 700bp a month ago and below 200bp prior to the credit crunch.
On this side of the Atlantic, the spread for the 5-year CDX high-yield index (CDX.NA.HY) is expected to break its November record of 1,525bp within days, given that none of the bailout money is expected to help the non-investment grade segment of the bond market. The CDX North American high-yield index includes debt issued by Eastman Kodak, Hertz, Radio Shack, DIRECTV, Bombardier and Nortel.
Driven largely by the optimism surrounding the $8 trillion worth of government rescue packages, the S&P500 has rallied 16% from its November lows. But, in an environment where even the key credit default indicator (i.e. the CDX North American investment grade index, CDX.NA.IG) shows signs of widening beyond 300bp (last at 270bp) within a matter of days, it is indeed difficult to see how any buying of equities can be justified. A parallel investment-grade index for Asian bonds traded at 440bp this morning.
In fact, any further widening of credit default swaps in the investment-grade and high-yield sectors will result in a panic rush for risk coverage. Already, risk insurance sellers in Europe are demanding sizeable upfront fees for popular issuers like ArcelorMittal, Lafarge, Glencore and Continential, as bond-holders determine that wisdom is the better part of valour. CDS pricing specialists are obviously not impressed either with the unprecedented interest rate cuts in Europe and England or with the growing realization that a zero-rate 2009 may well be on the cards.
So can the S&P 500 and Dow sustain their recent gains in the face of a 25% widening (from this juncture) of investment-grade and high-yield CDS spreads? And are some equity analysts generating a falsehood by advocating, implicitly or expressly, a fundamental disconnect between the growing crisis in debt on one hand and the bullishness in equities on the other? It might take some intense activity in the CDS arena to provide the requisite dose of reality but, leads and lags apart, look for the S&P 500 to be safely below 700 before any credible near-term bottom appears on the horizon.
Already, in the wake of the high degree of confusion cause by the flood of multi-tiered government-backed debt issues, sovereign risks on western nations have risen to levels which even seasoned traders could not have anticipated during the second-half of this year. The “spread-gap” between 5-year US government risk and 5-year investment-grade (North American) risk stands at 210bp today. Look for the investment-grade index to drag 5- and 10-year treasury CDS spreads into the 85-105bp range within weeks.
To reiterate, here are the “panic signals” which will force sharp declines in the S&P 500 and the Dow: the CDX investment grade-index breaching 330bp and the CDX high-yield index breaching 1,600bp. Short equities (SPY, DIA and QQQQ) this morning.
Disclosure: Author holds short position in SPY and QQQQ
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This article has 19 comments:
"CDS pricing specialists are obviously not impressed either with the unprecedented interest rate cuts in Europe and England or with the growing realization that a zero-rate 2009 may well be on the cards." yep, they are not... because they only look at the equity vol, which is affected by redemptions, which are affected by the higher CDSs etc.. on and on it goes...
That is reality.
It is amazing how many people who invest in stocks know little to nothing about the credit markets or hedge funds.
That is reality.
It is amazing how many people who invest in stocks know little to nothing about the credit markets or hedge funds.
We may very well see most of those indebted companies going bankrupt,leaving bondholders with perhaps even lower recovery rates than current bond prices suggest,while at the same time stocks in all healthy companies rise in anticipation of the next business cycle.
Europe is a different story and probably still has lot of downside.
First up, pricing errors and fear. The prime example was a couple of weeks ago the cost of insuring Berkshire Hathaway debt for five years exploded. Why? Apparently because of Berkshire's derivatives investments, wherein it sold puts on several market indexes, and under which BRK would have to pay if markets don't return to higher levels by the time these puts expire between 10 and 19 years from now. The potential cost to BRK, if all of the markets went to zero, is something like $37 billion.
So what's the problem? The CDS widening that occurred on BRK's debt covered only the next five years - during which time none of these options come due. The CDS market was claiming that BRK's liabilities that come due in 10 years made it many times more likely that BRK would fail in the next 5 years. Where's the logic here?
Now, risk aversion and a changed market. The fact is that the analysis of risk in debt markets has fundamentally changed in the last few months. Banks are reducing their leverage and raising capital in the face of losses many can't accurately quantify. Banks are unwilling to lend to each other at rates even close to what they were doing six months ago. We're seeing economic actors, across the entire debt market, circling the wagons. CDS is no different, and because fear is so central to it, the effect is greater than in the credit markets as a whole. This increased risk aversion should not be expected to return to pre-September levels soon, and indeed it may never return to that state. So comparing CDS prices today vs. three months ago almost certainly overstates the case the author makes.
In short, I can't have a huge amount of confidence in CDS pricing as a market indicator.
Gtarras:
waits for mean reversion, built some of these "models" and quotes Merton..
This is too rich..are you being funny ?? ;)
And of course your "models" took into account Citi's $300 B bailouts when you calculated the SD.
p.s. are you employed now ?
Someone said: Let There Be No More Leveraged Debt Industry
and POOF! It was gone.
The world is a better place for it.
Right now, every CDS out there is a credit risk squared, because the counterparty is less likely to actually pay on the CDS contract than the underlying is to default.
But the braintrust automatons who built the system cannot grok that the CDS contract itself is no longer trading as a nearly risk free AAA collateralized credit.
Half the governments on the planet are within an inch of just declaring CDS contracts unenforceable if not making their trade criminal, and these nutjobs are still pretending that everything else must be driven by their manipulated make believe.
I call "no clothes" on the CDS emperors. They are buffons, actual default rates on corporates will not hit half the current spreads, let alone loss rates. Buy the bonds and tell the CDS marketeers to stuff themselves.
And the dumb FASB accountants abet them by forcing financial institutions to value distressed bond prices that are influenced by CDS spreads.
And the SEC abets the sellers by removing the uptick rule, letting the sellers excecuting bear raids to generate fears.
It is nothing new.
> Regarding the BRK CDS example. My limited understanding is that
> BRK is required to put up more collateral on the PUTs they sold when
> the market moves against them, and has put up about the 6B that
> they sold the PUTs for in the first place. So it is reasonable
> to assume that BRK could face the same fate as AIG given a severe
> enough market move.
This is inaccurate -- per financials and other public statements, BRK puts up _NO_ collateral (for the next 10-20 years/maturity schedule of the options) -- even if the puts move against them by $20B or whatever.
The only exception is if BRK gets hit w/a ratings downgrade -- but even there, they've publicly stated (sure, maybe Warren's lying about that too) that the maximum collateral required even in that event is "far less than 1% of BRK's total assets" -- <<$2.8B as of 9/30/08.
Fyi, this is the kind of deal that no one but BRK could probably have pulled off...
So can spreads go higher? You bet! There's always a bull market somewhere, and that's where traders like to play. The bull market today is in CDS, and other bearish trading strategies. You see, once fundamentals are no longer in focus, panicking traders will pile into momentum-driven positions for fear of missing out. This seems to be what is happening in the CDS market at the moment - quite a bit reminiscent of the commodities bubble and internet bubble. Ah, nothing changes, does it?
Will higher spreads take down equity prices? Maybe. If people interpret the CDS spreads as deteriorating credit quality, sure. Or, maybe equity investors will shrug it off because all the stories about how the capital market is ending are getting stale. Without a fresh story that people can actually fall for, nothing but momentum will push CDS spreads up. Clever folks will want to close out CDS positions and book profits early.
I mean, I would. There was some easy money in this trade earlier this year, and I don't know. Call me a wimp, I don't care about the last 20% gains. CDS will be the subject of intense regulation next year - bills for regulating these trades are already on the Senate floor. Moreover, various Federal and state legal authorities are anxious to hunt down fund managers who may be charged with "manipulating" the CDS market. Either way you slice it's getting a bit late in the evening for the CDS party.
One thing is for sure, though. All bubbles pop. When spreads in the CDS market start to collapse, they will collapse explosively. It will be interesting to see what little bit of news financial authors will ascribe to the cause for the collapse. Maybe it will be a jobs report that comes out better than expected? Or, let me see... golly, I can't even begin to speculate what the future newsworthy "trigger" for falling CDS spreads will be. But you know what the real story will be? Watch the 65 day exponential moving average, verses the 200 day exponential moving average, on CDS spreads. When they invert.....
On Dec 04 07:42 AM peterthepainter wrote:
> fascinating!