Signs of Financial Stress First Appeared in Credit Default Swaps (CDS)

I was flipping through this month's Bloomberg Markets magazine and came across page 150 titled "Finding Stock Clues in CDSs". Here's a quote:
"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 borrowers initial underwriters in the loan origination and securitization process (imo). Or... Who the hell signs off on these deals?

Comments

  1. Great post, have you read The Big Short? Great read, this one 20 million dollar hedge fund outfit was getting laughed at by all the big banks trying to buy CDS and eventually Duetschbank sold some too them, they ended up doing like 150 out of those positions. Pretttyyy good. Just watch though, by the time the CDS ETF comes out the "New Normal" of government guarantee will make its chart look like FAZ.

    I like the idea of Gordon Gekko's buying voting rights via equity and then manuevering to devalue the bonds, governance arbitrage you might call it.

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  2. Exactly, Governance Arbitrage LLC haha. Don't you think the next blow up will in interest rate derivatives? First was mis-priced credit risk, next will be mis-priced interest rate risk that will drown banks paying floating rates. How does that end?

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  3. An information cascade into an abattoire.

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  4. Yeah I was thinking about the CDS ETF you mentioned. I want to know if a whole revolution in lending, securitization and credit insurance can occur? Why can't there be an "accredited investor" version of Prosper.com? If people, or really small investors/traders, are allowed to pay $7 commissions trading or shorting the riskiest portion of a public company's capital base, why can't bonds (and CDSs) be chopped up and traded on an exchange, like a SecondMarket Liquid Version? You would police the CDS Sellers capital base. A company would float some of their bonds on this exchange w/CDS market makers ready and willing to sell you insurance (in small numbers). I'm just trying to kill the CDS ETF idea and go straight to the source.

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  5. I was thinking about the CDS ETF you mentioned. I want to know if a whole revolution in lending, securitization and credit insurance can occur? Why can't there be an "accredited investor" version of Prosper.com? If people, or really small investors/traders, are allowed to pay $7 commissions trading or shorting the riskiest portion of a public company's capital base, why can't bonds (and CDSs) be chopped up and traded on an exchange, like a SecondMarket Liquid Version? You would police the CDS Sellers capital base. A company would float some of their bonds on this exchange w/CDS market makers ready and willing to sell you insurance (in small numbers). I'm just trying to kill the CDS ETF idea and go straight to the source. A hedge fund or three that builds this infrastructure would make $100s of billions.

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  6. Providing liquidity to retailers on a stat-arb basis is profitable but how do you dumb-it-down to the Farmville crowd? A "Short Credit Index ETF" or something kind of gets you there (relatively speaking) but what you're describing sounds too convuloted to attract enough punters. Sum it up for us in a sentence. Say I'm a guy with little money looking to make a big score betting on rare events. How does this serve me?

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  7. I'm not really talking about trying to get people to bet on black swans. I'm saying what if there's a new normal where retail investors have the ability to buy fixed insurance on municipal bonds, corporate bonds or indexes or Treasury bonds. Essentially providing a package of credit and interest rate insurance products to protect against credit and interest rate risk. I'm pitching this more for the wealth management retirement side or for individual bond investors. Bonds and CDS would need to be traded over an exchange (in mini transactions). Like you said a while ago, the cost of protection would probably rise right? Since retail would bid up the insurance. So it would ruin the profit potential for the big hedge funds, since OTC products would be unleashed to the public. I don't know what to say about that. If these products were available and they worked, people would pay up to protect their principal and return, and not have to maneuver in and out of the market, and pay commissions. Would that be too destructive for the industry?

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  8. It's basically saying, pay us ("the hedge fund") a fee so you can protect your portfolio if "things" go wrong, just like car, health or life insurance. Is it taboo to even talk about this?

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  9. The big problem with CDS was there wasn't enough cash in the pool to cover all the liabilities in the event of massive defaults, which the models said was practically impossible, which justified packaging more debt and underwriting it with CDS, and so on...

    If you got premiums bid up so that there was enough money, well it'd be like a market in put options for bonds instead of shares. Why not? But by that same token, you can buy puts on TLT, HYG ect. right now. You're referring to something more diffuse that can cover more specific issues?

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  10. Isn't there a way to kill the liquidity problem in the credit market? I'm thinking that's the main culprit. Banks and financial institutions control the majority of the debt of a public company or even loans, debt securitizations etc. Then they park it, buy CDS from another bank, credit fund or insurance co, or watch their empires come crumbling down because they f**ed up, and affect the entire economy. It's communism.

    Why, I ask, can't the "institutional" smart credit markets be unleashed for public consumption (from small time wealth mgmt clients, to online traders). I don't understand why we still allow these institutions to fully control this stuff if they failed demonstrably 2 years ago. This isn't peddling tech stocks to the public with no revenues, this is boring debt connected with insurance, which isn't risky if you can play like the big doggs.

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  11. Isn't there a way to kill the liquidity problem in the credit market? I'm thinking that's the main culprit. Banks and financial institutions control the majority of the debt of a public company or even loans, debt securitizations etc. Then they park it, buy CDS from another bank, credit fund or insurance co, or watch their empires come crumbling down because they f**ed up, and affect the entire economy. It's failed communism, no?

    Why, I ask, can't the "institutional" smart credit markets be unleashed for public consumption (from small time wealth mgmt clients, to online traders). I don't understand why we still allow these institutions to fully control this stuff if they failed demonstrably 2 years ago. This isn't peddling tech stocks to the public with no revenues, this is boring debt connected with insurance, which isn't risky if you can play like the big doggs.

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  12. Ok, I see what you're saying and that sounds better than writing puts on 100 shares of HL or whatever. If you've got the connections to get some depth on the tape and follow up with a decently designed retail platform, I could see this working, and there's always leveraged CDS trading for those who want to get wet.

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  13. That's the problem, I just have a voice. But it appears that SecondMarket is making big moves in this space. I hope they take over the game and become a "primary market" as well.

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