Wednesday, September 12, 2007

CDS Factors In Equity Valuation - Part B

This is the second in a series.

Part B: The Emergence and Growing Importance of The CDS Market

The initial creation of the Credit Default Swap market goes back before 2000, when CDSs were issued mostly against riskier sovereign debt, like Latin American or Eastern European government bonds. The market has since expanded rapidly to include corporate, ABS and index issues; amounts outstanding grew exponentially at an average of 110% per year and according to the International Swaps and Derivatives Association (ISDA) stood at a notional value of $34.4 trillion at the end of 2006 (latest data available).

Data: ISDA

Notional amounts are not market value amounts; that is, they represent the face amount of the credit insurance and not the value of the premiums that changes hands. That being said, notional amounts for CDS are not merely big numbers with little significance, as some claim*. One reason is that, unlike fires in California or earthquakes in Japan, credit events are not uncorrelated: a slowdown or recession creates financial pressure across most of the corporate spectrum, not just in selected areas. Globalization has also added a potent catalyst: weakness in retail sales in the US may, for example, rapidly manifest itself as factory slowdowns in China and less demand for cargo shipping everywhere. A butterfly flying in Peoria may create a storm in Shanghai and sink a ship in the Pacific, too.

Another reason that large notional CDS amounts matter is that, unlike regulated insurance companies, many of the entities that sell CDSs (i.e. those who provide the credit insurance) are less certain to maintain reserves for the potential liabilities they underwrite. It is unrealistic to expect that a 20x leveraged hedge fund has set aside a portion of its capital against the CDSs it sold to boost its performance.

Yet another factor has to do with timing: the CDS market grew exponentially exclusively during a boom cycle, i.e. when defaults were at historic lows and credit insurance became cheap. It has not been tested during a bust cycle and we will simply not know who is swimming in the buff until ebb tide. In other words, so far CDSs are a bull market phenomenon, when everyone claims to be a genius.

Lastly, under our legal system corporations are separate entities and their shareholders can walk away from corporate debt without personal liability. In other words, shareholders hold an implied "put" option on the company's debt: in bankruptcy proceedings they can "put" the debt back to the lenders and move on. There is good reason why lawmakers provide this legal immunity: it promotes enterprise by lessening the penalty associated with business failure. But the CDS market takes this immunity away from the overall economy and even multiplies the potential penalties: by creating multiple claims against a company's outstanding liabilities, CDSs may become economic penalty amplifiers during the "bust" cycle - which in no way has been abolished, despite claims to the contrary.

Let's pause here: the original debt put option still exists, incorporated within stock ownership of any given company "X". This put option certainly has some value and it must be reflected in the price of the stock. But through CDSs we have also created parallel and multiple puts on the debt of the same company "X" which trade separately and also have value, in this case clearly indicated by the market price of the CDSs. The amount of X's debt covered does not change, no matter how much CDS is written against it - but the writer of CDS insurance assumes the business risk of X, anyway i.e. he acquires a portion of equity risk similar to going long stock, without buying stock.

In effect, the CDS writer is creating phantom equity exposure in X, but X is not getting any direct benefit: no equity capital and no increase in its share price. Since the total equity of X does not change no matter how many pieces we cut it into (shares plus CDS contracts), it follows that each piece must be worth less, shares included. In other words, to the degree that CDS issuance acts to "water" the stock of X, it makes it theoretically less valuable.

Of course, real life is not that simple. The buyer of CDS may be a market maker without prior exposure to X and who thus may have to hedge his equivalent "short" position by buying stock or other equity derivatives from the open market. Through this process CDSs apparently act as volatility attenuators for stocks during boom cycles, i.e. when least needed. This readily explains the low volatility environment we observed in recent years, with stocks rising slowly and steadily exactly in those markets where CDSs were most prevalent: the US and Western Europe.

To gauge the overall possible effect of CDSs on equity values, I added the global market capitalization of all equity markets to the above chart (see below). Market cap is not directly comparable to CDS notional amounts, but as we saw above the connection is there and it is growing.

In the next posting I will examine current pricing of CDSs and its correlation to broad equity indexes.


(*) Also note: unlike earlier CDSs most current contracts are settled for cash, i.e. without the exchange of bonds or other specified securities. This is certainly true for index CDSs, which have become very popular. Ultimately, cash settlement means that one default event may result in multiple CDS payments that far exceed the real economic loss sustained by the default. As a reader commented (Shawn H), in such cases a company may be worth more "dead" than alive, or vice versa. It all depends which interests hold the stronger hand: the CDS buyers or the sellers. This is a distortive factor that can lead to highly damaging market manipulation.


James said...

There is no doubt in my mind that CDS exposure is going to be a problem relatively soon.

Anonymous said...

Again, great post. However it is frightning to me because it affirms my own anecdotal theory that there are equity price contingencies that will be triggered as equity prices decline or if they don't advance accordingly.

It appears as though we have one HUGE ENRON just waiting to implode.

New high in crude, new low in the dollar, gold holding the highs...

Some are saying that this is just a slight derailment, it looks more to me like if the train has jumped off the tracks and fallen off a cliff, let's just hope that it lands right side up in that ditch down there.