What, If Anything, Are CDS Spreads Telling Us?

Two weeks ago, when credit default swap spreads on US treasuries briefly breached 100 basis points, a worried Geneva-based private banker called into one of the better-known price makers to check on traded volumes. “My bosses are asking if we should start factoring default risk into our fair value measurements for government-issued and government-backed debt,” the private banker explained. But his quest for clarity actually led to more confusion and more uncertainty.

A spokesperson for the leading UK CDS quote provider explained that “figures on volumes transacted are confidential, you should be using our screens for indications only and the best way to get a firm price is to contact the major risk buyers whom I am not allowed to name on the record.”

This week, as CDS spreads for Berkshire Hathaway (BRK.A) and General Electric (GE) started to reach levels akin to junk, a director of a New York hedge fund holding hundreds of millions of dollars worth of investment grade bonds started to wonder if she should be disclosing the revised default probability scenario, implied by the CDS spreads, to her institutional investors: “We don’t want to create any panic but should we be informing our participants about what the CDS marketplace is telling us?”

What the CDS marketplace is telling us is that, an abundance of two-way quotes regardless, the number of entities capable of offering bond default coverage is extremely limited. An analysis of fundamental trends in the quote matrix tells us that, though the CDS marketplace by no means represents an efficient pricing environment, the recent widening of corporate and sovereign spreads at short notice does suggest a growing and broad lack of confidence in the longer-term debt servicing ability of issuers of reference instruments. Furthermore, as this writer has pointed out repeatedly, CDS spreads predicated on option-based computer models failed to take into account harsh global economic realities in previous months; and, for all practical purposes, even today’s CDS prices fall far short of adequately capturing default risks, domestically and internationally.

The development of credit default swaps as derivative instruments accurately reflecting default risks has been restricted by two formidable roadblocks: the failure of the rating agencies to respond to changing corporate and sovereign risk profiles on a timely basis, and the deterioration in the balance sheets of key CDS market-makers like American International Group (AIG), Citigroup (C), Credit Suisse (CS), JP Morgan Chase (JPM), Morgan Stanley (MS) and UBS AG (UBS). Both factors, embedded in CDS contractual documentation, have served to inhibit the maturity of the CDS derivative as the determinative vehicle to measure default risk probabilities.

As the Geneva asset manager concluded after his phone conversation with the CDS quote provider and after his review of the latest CDS spreads on his Bloomberg terminal, “despite the low or sporadic volumes, despite the lack of transparency on the pricing fundamentals, the trend within the CDS matrix is telling me that the risk on my bond portfolio has risen substantially in recent weeks and that equities are generally headed lower.” Well, the nature of the relationship between CDS spreads and equity indices is still being debated; but heightening perceptions of bond default risks are indeed damaging the balance sheets (in real terms) of numerous mutual funds and hedge funds, if fair value measurement mechanisms are properly applied, particularly in the case of debt paper with limited or near-zero liquidity.

However, it is unlikely that any asset manager is incorporating CDS spreads in portfolio valuations just yet; on the contrary, many on Wall Street are now selling the notion that, since the CDS marketplace is “effectively controlled” by a few professional market-makers, default probabilities derived from such spreads are almost irrelevant. That is a dangerous stance to adopt; those asset managers who thought that they had found the most prudent (and profitable) answer to declining equity prices (by switching to supposedly lucrative yields in the corporate and sovereign debt sector) will have to confront their investors with the facts, sooner or later. Admittedly, the inferences to be drawn from the CDS marketplace must be conditioned by its inherent limitations. But there is no denying the direction bond default risk is taking.

For reasons relating to confidentiality of information, this writer is not listing the mutual funds and hedge funds which are currently contributing to the growth of yet another component of overall systemic risk. Investors are best advised to check their holdings and to ask their asset managers for specifics risk sheets at the earliest opportunity. That is exactly what the CDS marketplace is telling all of us to do today.

Stock position: None.

Comments

[Fabien Hug:]

Sorry Sir but this is a load of crap. No volumes, no counter party, no disclosing of participants, no nothing and we should base our investment strategy on that! Great.
Now, some of these non-disclosed geniuses are willing to pay money to protect themselves against a default of the US gvmt or even a default of GE! Did you ever thought about who is going to fork the bill when such default occurs? AIG or UBS or Merrill-Bofa?
To me it sounds like oil $ 200 before Xmas, nothing more.

Mar 10 09:48 AM

[Rakesh Saxena:]

Fabian hug: You obviously don't read English very well. I am not suggesting that you base any strategy on the CDS marketplace; I am only pointing to what signals you can derive. Ignore them at your own peril. But do try to upgrade your writing skills so that you can write something sensible. - Rakesh


On Mar 10 09:48 AM fabien hug wrote:

> Sorry Sir but this is a load of crap. No volumes, no counter party,
> no disclosing of participants, no nothing and we should base our
> investment strategy on that! Great.
> Now, some of these non-disclosed geniuses are willing to pay money
> to protect themselves against a default of the US gvmt or even a
> default of GE! Did you ever thought about who is going to fork the
> bill when such default occurs? AIG or UBS or Merrill-Bofa?
> To me it sounds like oil $ 200 before Xmas, nothing more.

Mar 10 11:29 AM

[PROXIMO:]

Can't help but wonder if there wasn't, at some level, some reciprocal agreements between the rating agencies and the larger financial institutions. Hard to believe the rating agencies would have failed that badly unless they were on the take.

Mar 10 12:59 PM

[Fabien Hug:]

Dear Sir
Since the market is up 6% and GE 18%, I will take time to answer to your answer. Obviously, you don't like my remarks and I am happy to read that you also have great competences as an English teacher. By the way, sorry for my English skills, I obviously don't have your US education (since I spent the better part of my career with one of these Geneva's Private Banker, en francais s'il vous plait). Anyway, even if I like your beautiful language, I car more for my money.
Here is a verbatim of one of your sentences, amongst other; "many on Wall Street are now selling the notion that, since the CDS marketplace is “effectively controlled” by a few professional market-makers, default probabilities derived from such spreads are almost irrelevant. That is a dangerous stance to adopt; those asset managers who thought that they had found the most prudent (and profitable) answer to declining equity prices (by switching to supposedly lucrative yields in the corporate and sovereign debt sector) will have to confront their investors with the facts, sooner or later."
You don't want to call this a strategic call, fine with me. My opinion will remain (as long as there is no data available) that this is a big trading game as many on Wall Street seem to thing.
Good luck.

Mar 10 01:18 PM

[skwestorange:]

The author of this article must be more restrained in his criticism of the language skills of those who comment and focus instead on the content/message. Fabien Hug's comments are very valid. He merely questions the wisdom of using the data/info from the CDS market given its opaqueness and total control by a few.

Mar 10 05:02 PM

[discov:]

Thanks Rakesh, I have learned a lot from your articles. I have been staying out of bonds all together, not just because of CDS data, but because systemic risk doesn't care if you own common stock or senior bonds.

Ryan
concisetrading.blogspo.../

Mar 11 03:31 AM

[Mike Stathis:]

What I find remarkable is how the same guys who missed this financial apocalypse continue to follow useless theoretical risk models based on math. Too funny. I suppose they have little choice since they have no other training. In this case, myopia can be disasterous.

You can neither measure nor control risk using mathematical equations. The best risk managers have real trading experience. More important, they are leaders in thought.

Most Wall Street professionals have been fooled by these highly flawed risk models because they do not have math degrees. So when exposed to the intricate theorums and equations, they become hypnotized into thinking they have found some Holy Grail.

The few of us out there with a math background, real investment experience, and who are also thought leaders understand how to measure and manage risk. And we certainly don't use VaR and other bologna. We simply wait around to collect huge profits when these models fail. This is the easiest way to become very wealthy; that is, if you really understand things. Since very few individuals truly understand how this all works, you can imagine how much money is available for a select few.

The global investment community did not learn their lesson after LTCM. And they won't learn it after this crisis. The same cycle will repeat indefinately. And those of us who understand the various flaws buried within the models used by credit risk managers will continue to make huge profits, quite easily I might add.

Mar 11 04:19 AM

[mr freddo:]

Thank you Mr. Sexena for your insights. I have added you to my watchlist and look forward to your articles as I believe that while most of us don't really understand the CDS market, you do.

What I do know and have been saying for some time, is that the CDS market is what makes this crisis different than any other in history. So looking backward as most economists like to do, is less valuable than it may have been in the past.

What the CDS market has done is it has linked all or most of the worlds financial institutions together so tightly that the fall of one creates so much systemic risk that it cannot be allowed to fail. While we survived the Lehman Bros bankruptcy, we learned that another such bankruptcy could bring down the entire system.

Given your excellent track record, I would like to know where you believe this crisis is headed. It seems that there are 3 possibilities long term:

1. We muddle through.
2. The US goes broke trying to backstop the world's financial systems and throws trillions of good money after bad. A world wide decades long depression occurs and we all end up wearing barrels for clothing and living in tent cities.
3. We realize soon that the whole system is doomed and so the US lets the system crash and burn but prepares a plan for building a new financial system. Things are very bad for 5 years but we emerge from the carnage with a well regulated, less dangerous financial system.

While I am hopeful for Number 1, and fearful of Number 2, I wonder if Number 3 is the best route to pursue for our country and the world.

Last question for you: Since bonds are suspect and equities look bad to you, where should the average investor be parking their money?

Mar 18 01:45 PM

[Kartik Sharma:]

Dear Sir

Thanks for this useful insight in the intriguing world of CDS..first of all, I am no expert in the investment world as many of the people here..I am doing my B.Tech project at IIT Roorkee relating to CDS spreads and volatility in equity market and CDS spreads as indicator of investor confidence.
I am not able to digest the fact that default probabilities are irrelevant related to CDS market..also, do you think that CDS spreads are the single biggest determinant of investor sentiments..also( and dis one is for everyone who sees this) can you please help me in finding CDS spreads data for last 1 year for some firms.

Mar 31 12:21 PM