Wednesday, July 4, 2007

Gorillas In Our Midst

While the Debt Bubble was getting pricked here and there for several months (sub-prime, commercial real estate loans), I patiently awaited the next shoe to drop: Credit Default Swaps on corporate bonds. As I have written ad nauseam in this blog, within "modern" finance CDS's are the equivalent of a 3-ton gorilla raging inside a rather shoddy cage.

It is my firmly held belief that the explosion of CDS trading since 2000 was responsible for pushing long-term rates lower, even as the Fed kept raising short rates. In simple terms, risk premiums collapsed and produced what Greenspan termed "a conundrum" just before he left the Fed. This development produced truly monumental effects: it created the ocean of cheap liquidity that sloshed from Shanghai to Brazil and lubricated the dealings of thousands of hedge and private equity funds, pushing asset prices higher. But if this faux-bijoux liquidity (cheap & ugly) is taken away, the ocean will turn into a mudhole.

Indeed, this may be happening right now: CDS spreads are rising fast, as can be seen from the various CDX indexes that track them. Investment grade CDS's have jumped 10 basis points and high yield (i.e. junk) almost 90 b.p.

CDX-US Investment GradeCDX - US High Yield

CDS premiums are an excellent indication of effective interest rate spreads, i.e. what businesses and other non-government borrowers have to pay to finance their operations, from making mouthwash to placing multi-billion takeover bids. And the sheer size of the CDS market ($34 trillion at the end of 2006) is such that its effects cannot be ignored or be swept under the carpet, as was attempted with the sub-prime mortgages a few months ago.

Market "visitors" are therefore warned to quickly leave the grounds and let the attendant "pros" deal with the gorilla. After all, it was the latter that brought him in: I am reminded of the scene from King Kong where the beast is being exhibited to New York's tuxedoed and frocked social elite, chained on a Broadway theater stage. In this most American of films, the chains proved flimsy and the gawkers got the equivalent of a sharp lesson on the dangerous effects of low risk premiums.

Enjoy the fireworks!


  1. Very good comment on the rating agencies. Fault is not on them, fault is on stupid investment professionnals who forgot the principle of rating agencies : describing what they know and not guessint about the future ( which is precisely the investor responsibilty). However on the CDS do not expect the end of the world : it is correct to assume that thre rise in spreads is acting as a Fed tightning but do not forget that a lot of invesors have bought these spread at a lower level to hedge them against what is happening now. The net effect is not obious

  2. Dear miju,

    Perhaps my most basic concern with CDS's is that the amounts outstanding exceed by far the underlying bonds involved. Thus, defaults can cascade into many more losses than those actually experienced by bondholders, particularly now that most CDS's are written against indexes instead of single-name bonds.

    It's a bit like this: suppose a homeowner takes out flood insurance from 10 different insurance companies and demands to collect from all of them when his house gets damaged. And it's actually worse than that, because in CDS's ANYONE can take out insurance against that one house: a neighbor, a dentist in Paughkeepsie, a Dutch engineer or an Indian actor.

    This is a situation that has not been experienced before and - most crucially - has not been stress tested in real life conditions. Yes, the investment banks involved have armies of math PhD's modelling away all sorts of potential CDS disasters, but reality has a nasty habit of making fools of them, even if they have Nobel Prizes.


  3. Well, that's fascinating stuff indeed about how everyone can take out insurance on that one home located in the flood plain. And you hit the nail on the head about the PhDs being made fools of, LTCM anyone?