Distressed Volatility

The Lehman news is definitely widening spreads in the Credit Default Swap Market. I looked at the Liquid 50 Investment Grade Credit Default Swap Index Futures chart at cbot.com. They are priced in yield spread. I never really charted these securities before but they are driving the problems of this financial disaster because all of the big banks originated swaps to protect themselves from defaults on debt securities. When a big bank like Lehman, Bear and others become insolvent and sold a CDS security to back up some debt for another firm, it might not be able to repay the principal if the debt defaults; and what if Lehman re-insured that CDS swap with Bear Stearns, well the tax payers have it now. I'm not really sure if they do that but that sounds right if it happened. It's really crazy because these banks were investing in sub-prime real estate securities and at the same time protecting other firms making these same investments! It's also crazy how the book value means nothing whatsoever on Lehman's balance sheet due to all of their toxic debt investments and other liabilities. As Lehman stands at $0.22 today on the market, they're most recent quarter book value per share was $34.88, it's nuts how nothing was marked to market until it went bankrupt! Again here is the chart of the Credit Default Swap Index from the cbot and it's an investment grade index not sub-prime. As you can see in the chart we're still not at the March '08 highs of 420bp when Bear Stearns was sold but it did break out of the June '08 highs. This index should be watched because if things get worse this index could retest the Bear Stearns highs, however if spreads start to narrow and we don't hit those old highs we could be on our way down from the peak of the credit crisis. Let's just hope enough people don't listen to Professor Roubini at NYU and create a run on the retail banks.. Then it would truly be a great depression, and not just a structured financial great depression. I think after all of this we need to bring back the gold standard. We'll see how the other big I-banks and Insurance companies come out of this...



Here's a chart of the of 2006-2 AAA asset backed securities index, or RMBS, from markit.com, which quickly turned sour as you can see. It's priced like a bond, when these indexes are first originated they are priced at par or 100, the securities in this index were downgraded since the second half of 2006 which is reflected in the current price. Hedge fund manager Henry Paulson made billions of dollars in 2007 shorting this index. The index bounced off of the 68 resistance to the downside and could be headed toward the 61 support level.



The next chart from markit.com is the 2006 CMBX AAA tranche, or AAA rated commercial mortgage backed securities index originated in 2006 priced in spreads. You can see that spreads have widened recently and broke out of a downtrend. It could retest old highs.



Chart sources: markit.com, cbot.com