Tight CDX Spreads Don't Signal Unhealthy Appetite for Risk

Christopher Whalen wonders Will the CDO Machine Destroy Public Equity?. The first half of his article is about Credit Default Swaps and if they are symptomatic of something.

A brief introduction to the Credit Default Swap [CDX] market: CDX are contracts for insurance on bonds. In exchange for a fixed premium you can purchase protection against default on a notional $10 million of bonds. A CDX is a put option on a corporate bond that can be exercised upon a credit event. The person who sells the CDX gains exposure to default risk, and the person who buys the CDX loses exposure.

A really big market for credit risk has emerged, fueled by some people who want to get rid of credit risk and a greater number who wish to take on credit risk. In theory the spread of CDX contract plus a risk-free bond should equal the yield of the underlying bond. This is based on the assumption that the interest rate on a risky bond is equal to the risk free-rate plus a premium for credit and investment risks. Therefore CDX can be used to create synthetic positions which can then be arbitraged against real positions.

Just like in the futures market, the number of people who want to speculate on commodities is far greater than the number of people who actually need to hedge commodity risk. This has resulted in a grand shift away from Keynesian Normal Backwardation to a semi-permanent state of contango (forwardation). In the past, speculators demanded compensation for taking on commodity price risk; today they pay a small premium for exposure.

The same thing is going in CDX for popular credits. There is more demand for exposure to General Motors (GM) and Ford (F) credit risk than organically exists in the form of Ford/GM debt. Often it is cheaper to buy and sell CDX than the underlying bonds.

A huge industry of capital structure arbitrageurs has emerged who busy themselves with buying and selling CDX, debt, and equity, to take advantage of perceived mispricing of credit risk between senior and junior parts of the capital stack.

The net result is that there is a huge market for CDX, and it is not uncommon for the notional value of the CDX per issuer to far exceed the total amount of debt outstanding. This can lead to a humorous situation in which there is mad scramble for the defaulted bonds of the obliger because they are needed to redeem the CDX.

An additional source of demand for CDX is the synthetic collateralized debt obligation [CDO] market. Remember that a risk free asset plus a CDX is equivalent to the risky asset (in theory!). The bond market is not very liquid and bond dealers like to rip off clients who seek specific bonds and loan participations. So it is both cheaper and faster to set up a pool of treasury bonds and paper over it with CDX than it is to go out and actually buy the equivalent amount of debt.

All this newly created synthetic debt can then be bundled into a CDO. The CDO is financed with low-yield investment-grade debt in many tranches ranging AAA to BBB and it leaves behind a highly-leveraged equity tranche and management fees for the issuer.

The CDO can be highly structured to give every certificate holder what they want in terms of credit risk and return in the financing of the underlying portfolio. For complex reasons too technical to explain here (involving reinsurance of the upper AAA tranches), a synthetic CDO is often more profitable than a real CDO. Faster, more profitable, and with high fee's -- which is just what Wall Street likes to see.

So now we understand why the CDX market has grown so much. There is great interest in credit speculation. There are arbitrageurs and dealers creating a liquid market. And there is huge demand for the high returns from CDO equity and bonds from the investment grade tranches.

Whalen asks if the fact that CDX spreads for certain (GM)/(F) bonds is less than spread on the bonds themselves is a problem. He seems to conclude that it is symptomatic of a dangerous appetite for risk. Are tight CDX spreads a problem and are they caused by a dangerous appetite for risk? No. The tighter CDX spreads can be explained by a liquidity and utility premium.

Part two of this series will discuss the second half of Whalen's article, which wonders if the CDO market might finance the takeover of the world. (Maybe)