Joe's Greasy Spoon (Ask For Our CDS Special)

In closing yesterday's post on the plunge of the AAA, AA and A rated ABX indexes tracking Credit Default Swaps (CDS) on mortgage-related CDO's, I said:

"And did you know that at least 60% of all CDS's are held or sold by hedge funds?"

A friend soon called and wanted to know what I meant by that question. As an old finance hand, I often treat such comments as being obvious when, in fact, they are nothing but. Market inter-connections can be quite convoluted and confusing to the non-pro, so here is a bit further on the subject of CDS's and hedge funds.

Let me first start by saying that, in my opinion, CDS's and the yen carry trade are responsible for most of the additional leverage we have piled on markets during the last 2-3 years. So, the performance of the CDS market is extremely important right now, given that CDS's have been written against ~$35 trillion and their gross market value exceeds ~$500 billion, according to BIS and ISDA statistics.

As we know, CDS's are insurance contracts written against the default of an issuer's bonds. The seller of the insurance (the person who sells the CDS contract) undertakes the obligation to pay full face value in the event of default (up to an amount specified) and in exchange receives an agreed-upon annual premium for the duration the CDS contract, usually 5 years. The buyer of the insurance pays the premium regularly and supposedly hedges his default risk exposure. Neither buyer nor seller of the CDS are related to the bond issuer and can issue many times more CDS's than bonds outstanding. It is not uncommon to have 10 times more CDS outstanding than bonds in existence.

The crucial point I wanted to make with my original question/comment about hedge funds is that insurance contracts are not fungible. It is one thing to buy default insurance from The Rock of Ages Insurance Co. and quite another to buy it from Joe's Greasy Spoon and CDS Emporium. What is the real worth of credit insurance, when most of it is underwritten by notoriously risky, leveraged and unregulated hedge funds that can literally evaporate within days? The latest episode with Bear Stearns's funds makes this perfectly clear. How good is that credit risk hedge you have on your books if you bought it from "Joe's"?

The theoretical notion that underpins the creation of the CDS market is that it spreads credit risk around and thus makes the whole financial system more robust. This is very clearly questionable, in practice: all we did is that we created one more fat layer of risk in the system, constructed by and populated by the most volatile and leveraged residents in the financial universe: hedge funds. And yet, for a while, the market treated CDS's issued by "Joe" as being just as valuable as ones issued by "The Rock". Overall credit spreads plunged to historic lows, as hedge fund "Joes" muscled into the CDS market, venally cutting premiums to the bone in order to collect extra cash and boost their performance numbers, so crucial to their annual bonuses.

But if Mr. Market may on occasion become and stay irrational far longer than seems logical, he ALWAYS sobers up and almost always does so in violent fashion. That's what Crashes and Panics are, after all: sudden re-adjustments in reality perceptions. The ABX indexes are now re-adjusting to reality across their full spectrum, from AAA to BBB-, as we saw yesterday. And so are their less well-known commercial real estate counterparts from Markit, the CMBX indexes. The CMBX charts below track yield spreads, so the higher they go the higher the implied risk.

First, the AAA CMBX tranche:
Next is the AA tranche:
...and finally the A tranche (for comparison, the riskiest tranche rated BB has gone from 477 bp to 697 bp)
In layman's terms, the abrupt rise in CMBX spreads means that commercial real estate loans are suddenly becoming much more expensive to obtain. Given the sensitivity of commercial real estate projects to financing costs, this will very quickly lead to a gap-down in commercial real estate activity, the last vestige of relative strength in the otherwise reeling construction business.

On to my final point: credit spreads are rising in the corporate bond market, as well. This is where the big, ugly dragon of credit risk still sleeps: the risk of corporate defaults, so intimately and incestuously linked to the stockmarket. As the charts below make perfectly clear, the dragon is finally opening his eyes and, oh boy, does his fire-breath smell bad.

The CDX index for high yield bonds has widened from 260 bp to 400 bp. This means that financing risky LBO's and related M&A activity has become that much more expensive, likely killing for good any and all deals still in their early phases. Deals in the final stages may get re-priced, reduced in size or cancelled altogether, depending on a) how much "room" they have in their financial projections and b) how much "pull" the customers have with their bankers. Either way, I wouldn't put a single cent into such deals right now.

CDX High Yield

The CDX index for investment grade corporate bonds (they average just BBB+, read post from July 7th below) has widened out to 50 bp vs. 30 bp in January (unfortunately the chart below doesn't go that far back). A "mere" 20 basis points (0.20%) in financing costs may not seem all that much to a casual reader, but it is not chump change to a corporate treasurer counting his nickels and dimes, particularly since it is happening fast and shows every sign of going higher.

Besides, what is more important to the overall market right now is that it signals a sudden rise in implied risk and volatility for corporates, threatening the puzzlingly stellar performance of stocks.

CDX Investment Grade