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.
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!