"This year's fiscal turmoil in Europe and the market slump of 2008 have something in common: Both had their roots in debt. Be it Greece in 2010 or Lehman Brothers Holdings Inc. and General Motors Co. two years ago, some of the earliest signs of financial stress first appeared in the credit markets--specifically, credit-default swaps--before spreading to other asset classes such as equities." (from the October issue)
Credit default swaps are insurance contracts on a company's bonds that trade over-the-counter between banks, institutional investors and hedge funds. There has to be a way for smaller "accredited" players to get involved in a liquid and more transparent CDS market, since "too big to fail" obviously didn't work. How about a revolution in securitization as well? I'll give more thoughts on this later.
Price moves in credit default swaps provide "material" (in my opinion) information on underlying credits and have more credibility than the actual credit rating. If CDS prices spike dramatically, either a bank or hedge fund is speculating on higher default risk, nervously hedging underlying long exposure, or as billionaire hedgie George Soros put it,
"Some bond holders own CDS and they stood to gain more by bankruptcy than reorganization. It's like buying life insurance on someone else's life and owning a license to kill him" (video link on this post)
The Bloomberg article reinforced the fact that price movements in over-the-counter CDSs, combined with option activity, can be used to bet against misinformed equity investors (sheep) using their Credit-Equity Hedge Analysis (CDEQ) function. Bloomberg provides a few quotes on their website for free (see 1, 2), however, to get initiated in the CDS data club you have to pay up at Bloomberg, CMA Datavision, Reuters, Markit etc. It might be more than your rent.
To exacerbate the confusion even further, The SEC doesn't require CDS contracts to be reported in 13D filings. So a fresh 5% equity owner of a company could really be hedging against a massive short in credit. How can a publicly traded company have private derivative contracts outstanding that bet against the underlying bonds, with the potential motive to profit off the company's demise? I don't get how that makes markets more efficient. Shouldn't this data be on Finra.org in the bond market section? Or at least be provided in online brokerage research as indicators? If you want to know more about CDS contracts, see this Goldman Sachs CDS 101 presentation.
I'm not even talking about the CDSs that hedged against and/or profited from our country's subprime mortgage crisis and blew up the bond insurers. That was the main tip off of the financial crisis, recession, and quite possibly the end of U.S. growth for 6 years. Lastly, I'm wondering if the corrective mechanism in the mortgage market (widening spreads) would've occurred earlier if credit protection wasn't available via banks and insurers. Or were banks on a mission to blow themselves up either way, with the help from credit rating agencies mispricing debt and artificially low rates.
Again, I'm all for credit default swaps, debt securitization, CDOs and peddling loans, but it's like the 2008 financial crisis never happened. The entire system needs to change and prices need to be unleashed to the public, so when the next credit crisis and debt deflation depression (in nominal terms) hits the economy, nobody will be blamed except for the