CDS Market: It's Crunch Time

One of the first things that was drilled into me as a young analyst almost 20 years ago was "buy on the rumor, sell on the fact...", and that old adage certainly applies to the TARP rescue; my strategy since August of selling every short-covering rally in equities and commodities has proved lucrative.

The consensus was for a bounce Friday on the delayed approval, and yet we saw a 500 point reversal on the Dow and US markets testing new cycle lows. The technical condition of equity markets remains dire, and points to a potential imminent selling panic, or more emotively, a crash. We certainly face a testing time in coming weeks, as Q3 earnings reports in the US begin flooding in, many of which will surely disappoint, but more importantly the unraveling of the recent default events in the $53 trillion Credit Default Swap [CDS] market. We face a Fannie and Freddie auction on October 6, then Lehman is settled on October 10, and WaMu is scheduled for October 23. There is $500 billion outstanding in Fannie and Freddie alone, and that will be a key event to watch tomorrow; crucially, the CDS market, which became a wild casino in recent years, has a nominal value bigger than the global economy, and most bonds are hugely over insured i.e. have CDS written on them way in excess of the bond issue size.

Anybody could bet on a bond defaulting, regardless of whether they owned the underlying asset. The ISDA will determine the defaulted bond value in an auction with market makers (some Lehman bonds are trading in the market at sub 20c on the $ for instance) and the CDS writers will then have to stump up the difference in value, assuming they have the cash to do so.

All those hedge funds (and they were the second biggest writers after banks, I'd expect 2,000 plus hedge funds to implode in coming months), insurance companies and Belgian dentists who wrote insurance cover on bonds in these defaulting companies will be required to pay billions to bondholders, and my bet is many just won't be able to, causing systemic chaos.

One of the key failings of the TARP is its ludicrous complexity, so that it will take a month before the first auction can be set up, and the scale of bank participation is a total unknown. Meanwhile the sudden collapse of the $50 billion rescue plan for German bank Hypo Real Estate this weekend, and the failure of EU leaders to agree any coherent Europe wide rescue plan, will pressure the Euro even further.

US banks shamelessly sold their worst toxic sludge to gullible European banks and insurance companies, and the clean-up costs will be enormous and destabilizing. Several other leading European banks such as UniCredit in Italy look vulnerable after the collapse of Fortis in Belgium. In response to the Hypo crisis, Germany has apparently guaranteed local bank deposits, following the lead of Ireland and Greece, and obliging other EU members to follow suit rapidly or suffer capital flight. Fine in principle, but the balance sheets of many of these banks dwarf government revenues; Hypo alone has €400 billion in assets, and needs upwards of €100 billion in refinancing through end 2009.

The Eurozone will almost certainly be in recession by early 2009, and the current ECB rate policy is unsustainable. I'd expect Eurozone rates to tumble from 4.25% to 3% by mid 2009, and in the UK from 5% to 3.5% or lower. The first move may come within days, perhaps co-ordinated with the Fed and Asian central banks, so expect further extreme volatility.

In the panic equity market sell-off which may be looming, buying opportunities will abound for cash rich investors in those quality names in areas like agriculture and materials, where I believe there is a strong secular growth story, and which have already halved from their peaks.

Near term risks remain firmly to the downside, until the paralysed credit markets show material improvement (watch the TED spread), and we see a sequence of 90% up days in equities reflecting genuine technical strength.

In the meantime I'm staying short of both commodities and equities.

Comments

[venividivici:]

Very good article. Right on the money

2008 Oct 07 04:43 AM

[venividivici:]

Interesting to note that the Royal Bank of Scotland is down 45% this morning, Barclays 24% on a rumour that the three biggest banks have asked the Treasury for massive cash infusions.

2008 Oct 07 05:26 AM

[BigBadBank:]

The Fannie/Freddie auction has been and gone and heaven did not fall.

2008 Oct 07 05:55 AM

[Sean Maher:]

Good point re Fannie and Feddie, see latest blog post re closing my short positions (the one above was actually posted on the blog on 5th October, SeekingAlpha are a bit slow these days!)

2008 Oct 07 09:07 AM

[jklondon:]

senior lehmans bonds trading at about 10cents to the dollar but huge spreads between the dealers

2008 Oct 07 10:21 AM