Wednesday, January 9, 2008

A Gross CDS Warning

PIMCO's Bill Gross is easily the most influential fixed income money manager so what he says counts, even when talks his book (as he should). His latest monthly Investment Outlook focuses on the shadow pyramid banking system that has arisen during the last few years and on the effect of potential Credit Default Swaps (CDS) losses, which he calculates at $250 billion net of recoveries. He lays out his case in a clear and straightforward manner that is both easy and enjoyable to read. Highly recommended.

Confirming his view, the current action of the CDX indices for investment grade and junk corporate CDS is very poor: spreads have jumped to 96 and 564 basis points, respectively. These are record highs for the indices and mirror the weakening stock market environment - a correlation that I have constantly emphasized in this blog.

Furthermore, I believe that Mr.Gross's underestimates the potential losses. It does not account for the possibility that thinly capitalized speculative CDS sellers (e.g. hedge funds) may be unable to fulfil their insurance obligations, thus rendering opposing hedges worthless. The troubles at credit insurance monolines (and Mr. Buffet's decision to start his own) make this quite clear.
P.S. Three totally unrelated stories which I found interesting:


  1. Gross is a socialist, whining about how the government should bail homeowners and lower interest rates, neither of which are long term answers to the long term problems.

    Good analysis, scary scenario but hardly panacea.

  2. "...but hardly panacea...."

    Like I said, he's talking his book.


  3. The data about German retail sales matches an item about retail sales in the UK that I just posted in the comments to your 'Decoupling' post.

    Also earlier another UK retailer got clobbered after warning, noting in particular that holiday demand for laptops was especially weak; laptops have been a big driver for overall PC sales recently.

    Currys owner DSG warns on profits

    Shares in DSG plummeted 27% today after the electrical retailer warned on profits and a "more cautious" outlook this year following a poor Christmas for laptops.

  4. CDS on CFC:

    Some questions HEL & others:
    1) Does anybody know how much Credit protection was written on CFC?
    2) What are the scenarios of CFC becoming insolvent: FDIC, Fed, BofA - how will an 11 filing be avoided by recapitalization?
    3) Is CDS language legally standardized/evolved enough to handle the complex challenges of a bank-bankruptcy ? Would counterparty money enter at the same seniority level as junior bonds?


  5. Hell, can you please tell me what REAL long term interest rates are right now?

    If I was a gold bug (which I guess I am a very little) , wouldn't I be saying that the markets/fed are letting all these people default this very minute? Indeed, that the amount they are defaulting by just gets larger and larger every day? Remember, they don't have to actually default on a loan to 'default', if the money is worth less and less every minute. We are not on a gold currency standard anymore.

    Accrued interest has also been saying 'there is a disturbance in the force' on his blog... I thought equities have historically tended to hold up somewhat during hyper inflationary periods in nominal terms, they have just not held up much in real terms.

    Please tell me if I have this wrong?

  6. Thai:
    For 28 years I have said, "In the old days you went bankrupt. You gave your assets to the bank. It sold them and got 50 cents on the dollar. End. Now you go to the Fed. It prints money. You pay the bank 100% in 50-cent dollars". You got it now. Get gold.

  7. personally I'm ont sure Bill Gross gets it. I've followed his interest-rate calls over the years and some of them have been shockers. anyway, maybe he does tlak his book.

    I'll just say this...CDS contracts are between 2 counterparties. if one set of c/p's loses $250bn, the other set will make it. zero-sum game. yes some counterparties may write so much CDS that they'll go bust and not make full payouts. but CDS ultimately allows efficient risk-transfer. why does no-one mentioned interest-rate derivatives any more? they are way bigger than CDS. As a wise man once said..."These aren't the droids you're looking for".

    hubert, re: CFC CDS:
    1) Loads (and i bought a lot of it when it was trading in the 20's...and I am talking 20bps not 20% upfront!!)
    3) yes i think so. a cds contract is relatively simple. if CFC declares bankruptcy, the contracts are settled 3 days later by the buyer of protection delivering an eligible defaulted bond of Countrywide to the seller of protection in the notional amount (that's the face value of the bond, not the current trading value), and the seller pays the Par (Notional) amount to the buyer.

    We in the trade call it Par minus recovery.

    Very simple.

    The complexities of bankruptcy will be sorting through all those bond claims, or even claims where CFC itself has written derivative contracts (I assume this would mainly be interest rates).

  8. contractual variability in what constitutes a credit event has been overcome? no longer differences between ISDA and rating agencies? mispricing is a thing of the past?


  9. Hellasious,

    There was a talking head on CNBC today or yesterday and he was talking about the possibility of a consumer driven recession. During this, he pulled up a graph of consumer vs. business spending on which he pointed out that consumer spending had been fairly steady over time but that business spending was highly volatile. He also mentioned something about GDP being 70% of GDP, but I was not paying enough attention to hear the context.

    Anyway, the gist was that consumer spending is always fairly steady so it cannot cause a recession; rather, drops in business spending can cause recessions.

    I'm not so sure that I agree with his analysis. Thoughts?


    Sorry, that should say, "He also mentioned something about CONSUMER SPENDING being 70% of GDP, but I was not paying enough attention to hear the context."

  11. Anonymous, you poor fellow, you obviously haven't noticed it, but socialist nations generally have a higher standard of living than we do here in the capitalist paradise.

    As for lower long term rates, they are coming down because the economy is entering a recession that may well morph into a Depression. Mortgage holders are going to get some relief in that area.

    And speaking of a recession, I recommend to all you readers to check out Bob Bronson's piece over at Financial Sense.

  12. Gross has made a number of predictions over interest rates over the past five years that were way off. PIMCO is a big bond trader so I would bet that what Gross says is motivated more by PIMCO's trading strategy than what he really thinks. His predictions have been up and down. In contrast, the duration of PIMCO's bond portfolio in PTTRX has been almost flat over the past five years.

    If he really believes what he says, he should just shut up and increase the duration of the bond potfolio in PTTRX by 5 or 6%. That sure hasn't happened and I don't expect it to change soon.

  13. "increase the duration of the bond portfolio in PTTRX by 5 or 6%"

    I meant 5 or 6 years. Duration indicates the percentage change in price for a given percent change in rates, but it is still calculated in years.

  14. Gross is a socialist

    Mentioning socialism is really dreadful here. Come on! Move around the planet.

    Go to places like North of Europe (highly socialist) and pay attention to the way people grow, live and work.

    Go to places like China (highly socialist) and pay attention to the way people grow, live and work.

    Come back home. Check the way "finance" makes money. Then check the way people grow, live and work.

    Be fair in your judgment. Do not focus on the situation of your OWN upper-middle-class.

    I'm old enough to remember the 70s in the US. This country courageously fought back during the 80s. I mean real hard work. It has evolved negatively in the last 10 years or so.

    The way the upper class is using financial wizardry "à la Goldman Sachs" stinks.

    Ain't no better than the way some Chinese officials handle the development of their country.

    This country (yours) will needd nothing like socialism but some tough regulations and a better political agenda.

  15. This country courageously fought back during the 80s.

    Yeah, borrowing money like crazy to keep up.

    After the 1981 tax cuts took effect, the CBO cut its estimate of tax revenue for 1982-87 by $294 billion. But tax receipts were actually $205 billion lower during those years than the CBO's already reduced estimates -- numbers that might have been even worse if some of the 1981 tax cuts weren't reversed by Congress in 1982, the CBO said.

    Part of that additional shortfall was due to the effects of the 1981-82 recession, but the 1982-87 revenue drop is the kind of thing that makes most economists say the "trickle-down" theory is a load of bunk.

    "Like it or not, the experience of the 1980s demonstrates that supply-side tax cuts are not self-financing," Morgan Stanley chief economist Stephen Roach wrote in a research note. "Similar results have resulted from the Bush tax cuts."

  16. anon, speaking of the 1981 Tax Act:

    'With the 1981 act, the tax-shelter floodgates opened. By 1983, studies by Citizens for Tax Justice found that half of the largest and most profitable companies in the nation had paid no federal income tax at all in at least one of the years the [accelerated] depreciation changes had been in effect. More than a quarter of the 250 well-known companies surveyed paid nothing at all over the entire three-year period, despite $50 billion in pretax U.S. profits. General Electric, for example, reported $6.5 billion in pretax profits and $283 million in tax rebates. Boeing made $1.5 billion before tax and got $267 million in tax rebates. Dupont's pretax profits were $2.6 billion; after tax it made $132 million more. CTJ's findings were similar in 1984, 1985 and 1986.'

    Which, while partially corrected in 1986, has continued on. Someone mentioned 'socialism', well, evidently free market corporations prefer the one-sided variety.

  17. Very interesting the new from Germany.

    But this does not mean that people isn't buying.

    Prices of some electronic appliances dropped impressively in the last year: there is a huge competion on prices that eats away at earnings.
    Flat TVs, monitors, printers... all dropped impressively in prices: visit any retailer and have a pitiful look to their miseries ;)

    Here in Italy at the beginning of january there were massive sales on appliances (20-30% discounts on all inventory at some stores, things never seen before).

    I believe this is a sign of production overcapacity.

    About laptops sales: vista is a bad seller and there is no big issue in the Personal PC arena since some years now. I am still working using a 3 1/2 years old laptop with XP pro: can somebody explain me why should I switch to vista?
    For some fancy rotating graphic? And to get a slower OS?
    "the yawn is now"...

    regards and happy new year to everybody