I sometimes hear people at rating agencies talking about when credit conditions “get back to normal”. Do any of us really know what “normal” means, though?
The issue here is that investor incentives are simply not what they used to be. For example, in the good old days, a bond holder wanted to get repaid. Nowadays, the bond holder can go out and enter into a credit default swap (hereafter, a “CDS”), and offset (or maybe more than offset) any losses on his bonds just in case the bond issuer goes bankrupt. Needless to say, this state of affairs completely changes the bond holder’s incentives. And changed investor incentives will sooner or later change the very structure of whatever market the investors happen to be in. The important thing about that is that when the structure of the capital markets change in a fundamental way, nothing “gets back to normal” ever again. “Normal” is now something completely new.
Let me explain what I see as the new “normal”, using the following hypothetical. Suppose I have about $1,000,000 that I have to invest. One thing I could do is that I can buy a “risk free” 10-year U.S. Treasury that will yield 2%. I have another choice of investment, which is that I can buy a 10-year senior secured General Electric (GE) bond that yields 10%. GE is riskier than the United States government, and hence the extra yield on the GE bond. So far, sounds pretty “normal”. Let’s keep going.
Let’s suppose that I can buy a CDS insuring $1,000,000 worth of notional principal on GE debt, for $10,000 – call it a 1% spread. Setting aside my counterparty risk on the CDS, if I buy $990,000 worth of GE bonds and $10,000 worth of CDS, I have just turned my GE bonds into “risk-free” bonds because if GE defaults, I make $1,000,000 back on the CDS. Now here is where it gets interesting. See, Treasuries pay me 2%, but after I back out the cost of my CDS, the GE stuff is paying around 9%. Get it? Same risk on the GE bonds and CDS investment as I would have on an investment in U.S. Treasuries, but I pocket an extra 7% owning GE bonds insured with a CDS. Nice arbitrage opportunity.
When most of us think of “normal”, we think that when the market gives you an opportunity to make money risk-free, that opportunity will get arbitraged out of the market quick. Real quick. Investors will just buy up GE bonds, driving down the yield, and will buy up CDS, driving up the spread, until the risk-free US Treasury yield is going to be almost exactly the same yield as a GE bond + a CDS.
But that is not what is happening. There is a dichotomous force at play, which is that in today's “normal” market, when the price of a CDS goes up, that “normally” signals to investors that the creditworthiness of the bond issuer is going down. And when the creditworthiness of a bond issuer goes down, lots of investors sell the issuer’s bonds, and that, in turn, means that the yield on those bonds goes up.
See, what we have here is that we have this arbitrage opportunity (the one I describe where I make 7% extra on GE bonds hedged with CDS compared with what I’d make on US Treasuries), but instead of this state of affairs driving up the demand for GE bonds, it’s actually driving the demand for those bonds DOWN, because people see that increasing CDS spread and they freak out and say “oh golly, GE is going bankrupt, time to dump GE bonds!” And in so doing, the yield on those bonds goes way up (let’s say, hypothetically to 15%), and now the risk arbitrage opportunity is even larger.
Well, okay. Maybe yes, maybe no. Maybe, as the yield on GE bonds in this example pops to 15%, the spread on the CDS goes way up also – assume, hypothetically, way up to 8%. So, a risk arbitrage guy maybe isn’t making an even larger spread, but for those with a somewhat longer term strategy, this is a case of spending a little bit extra to get a lot extra. These chaps actually WANT to pay more – a lot more – to buy CDS insurance policies if by doing so, those increasing spreads will make some pension funds dump their GE bonds like a pack of lemmings diving off a cliff.
We've all seen how that works. Welcome to the new “normal.”
Who can say how it will play out – I’m not here to offer predictions. My only point is that the incentives and opportunities today are different from yesterday, and so are the rules. To make heads or tails out of why GE just lost its top credit rating, or why Berkshire Hathaway (BRK.A) just lost its own, an investor needs to consider that it may have nothing much to do with these companies’ balance sheets or the economy. And don’t let some analyst at a rating agency (stellar track record that these guys have when it comes to pricing risk) tell you any different.
As I said earlier, when incentives change, rules change, and when the rules change, the structure changes. We're at the stage where the structure is just starting to shift, and it's tough to really see any place for rating agencies.
Disclosures: The author owns shares of General Electric and Berkshire Hathaway.
