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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 (NYSE:BRK.A) and General Electric (NYSE: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 (NYSE:AIG), Citigroup (NYSE:C), Credit Suisse (NYSE:CS), JP Morgan Chase (NYSE:JPM), Morgan Stanley (NYSE:MS) and UBS AG (NYSE: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.

Source: What, If Anything, Are CDS Spreads Telling Us?