CDS: The Equity Connection Today

On November 29, 2007 I posted an entry titled "CDS: Phantom Menace". The following is an excerpt:

CDSs are equity substitutes carried at zero margin, masquerading as credit instruments. They create a feedback loop mechanism to equity markets that results in reducing volatility when things look good and increasing it when they don't. In other words, they work as risk amplifiers and not as risk attenuators.

... we have the potential for a financial viral disease of pandemic proportions. The CDS market is so new that it has never been tested on the downside of the credit/business cycle. We simply have no inkling of how it will behave under real life duress, when major credit events occur with increased frequency and magnitude.

I am not re-posting this to reap accolades for accurate prediction abilities. Rather, I want to stress two points relevant to today's situation:

a) All CDS trading counterparties are now - finally! - required to post margin, i.e. collateral. Furthermore, what was up to now a strictly OTC business is about to become significantly more organized and transparent through the involvement of established futures exchanges (ICE and CME are both vying for the business).

Thus, two of the major factors that previously allowed for unbridled speculation and opaque practices are being removed. That's a good thing, but it is definitely putting pressure on participants (and prices) in the short run.

b) CDSs acting in their role of phantom equity are now in reverse mode, causing substantial downward pressure on share prices - just as they artificially boosted share prices on the way up.


In my opinion, the two points taken together go a long way in explaining why CDS's for GE and Berkshire Hathaway are trading at puzzling levels, similar to those for much less creditworthy companies. For example, even though Warren Buffet's company has $25.5 billion of cash on hand and a AAA credit rating its CDSs "cost as much as those of KB Home, the homebuilder that lost money for seven consecutive quarters."

Things are just as bad for GE. "Sellers of credit-default swaps tied to the debt of General Electric Capital Corp. for five years yesterday demanded 16.5 percent upfront, in addition to 5 percent a year, according to broker Phoenix Partners Group. That means it costs $1.65 million initially and $500,000 annually to protect $10 million of obligations. The cost was $446,000 a year two weeks ago."

But at long last somebody is putting two and two together: CDSs create "phantom" short (or long) stock positions. From the same Bloomberg article:

"Because an average of just 1,550 Berkshire shares are traded on public exchanges, it’s difficult to borrow the stock to bet against the company through short sales. So, speculators may be buying credit-default swaps to hedge against equity losses, said Backshall of Credit Derivatives Research. "

Obviously, this kind of trading is not restricted to shares with low trading volume - in fact, I believe the exact opposite is happening, given the opportunities for arbitrage and manipulation in CDS - equity spreads.

So, what am I trying to say here? Simply this: as CDSs were partly responsible for driving the stock market to unsustainable highs 18 months ago, likewise today they are causing technical downside pressure, unrelated to corporate performance and economic conditions "on the ground".

The finance tail is, once again and quite noticeably, wagging the economy dog. That's pretty dangerous stuff for a nation - and even a President - that remain in thrall of daily index gyrations.

Note: A reader already had a question which perhaps many of you share:

"Would it be possible for you to elaborate a bit further on how CDS put pressure on stock prices today?"

Sure.

Here's one way:

Let's say you are a bank, insurance co. or hedge fund and have already sold CDSs (i.e. written credit insurance) in the past, on XYZ Motors debt. You now wish, understandably, to reduce your exposure.

You can:

a) Buy offsetting CDSs (not at all easy these days, very expensive and fraught with counterparty issues - remember, this is strictly OTC business still) and/or,

b) Short XYZ stock at an appropriate correlation ratio.

Even if you manage to accomplish all you need with option (a), whoever is selling you the CDS will need to hedge - assuming he's opening a new position and not closing an old one. Most likely hedge? Shorting XYZ stock.

The above example also applies if you are only doing "dynamic hedging" and not reducing overall exposure. Effect is the same, in the end - pressure on common stock of XYZ.

Come to think of it, there is a very intriguing aspect to this situation. If the current CDS mess is - somehow - quickly resolved on a comprehensive level (one example would be through migration of all the business, including open positions, to an established exchange and thus common clearing), then we are looking at lots and lots of short positions that may not be exactly necessary... .... .... fill in the blanks.

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