Everyone already knows that CDS spreads are blowing out and going beyond parabolic on the eurozone countries. What is equally as surprising is that no one is talking (YET) about the CDS themselves. People are selling them at different prices along this move, which means someone is left very short. Selling insurance is a great business…until the disaster strikes, at which point the insurance company prays that they have enough carry to cover their costs. In the case of CDS securities, the combination of never-experienced volatility with high leverage is going to become an issue. I don’t know which institution will break first, but someone must be sitting on significant losses and with year-end approaching fast, I wouldn’t be surprised if we start hearing some bad news from the big CDS-issuing banks.
We often speak about the difficulty of timing. On an individual position level it’s difficult, but alas, necessary, to predict the size of the move and risk, the specific position where it will occur (implementation), and the timing. It’s especially true for securities that have embedded time value/decay such as options or futures. For some securities however, looking at the entire curve can give you a sense at least of the market’s expectations for the timing. In the case of futures we discuss (too often?) how backwardation and contango can impact the implementation. In the case of the yield curve, well…you know my thoughts on the coming bear market in the longer parts of the curve.
ft.com has a posting on the structure of the CDS for Spain and Hungary. In short, these curves are showing that the market expects both to default sooner rather than later, or at least that IF they default, it will happen sooner rather than later (that’s a very fine but important different since the market isn’t expressing that they WILL default, just when to expect it IF it happens – it’s an issue of conditional probabilities).
For the full article, click here.
Everyone is talking about Plosser discussing selling off the Fed’s MBS hoard. It’s obviously necessary, but completely unfeasible given a still shaky housing market and no lending. Additionally, it would fly in the face of the Fed’s QE campaign. Lastly, who’s going to buy the securities?
http://www.marketwatch.com/story/fed-should-sell-mortgage-backed-bonds-plosser-2010-02-17
So the Fed is left holding the bag for now. You’d think that at least they should start tightening requirements and lending a bit less, instead of trying to dump their holdings. But alas, no.
Instead, the government is taking over private debt on a monumental scale. For an excellent analysis of where do we see deleveraging (and NOT), check this out: http://www.ritholtz.com/blog/2010/02/is-the-second-leg-of-the-credit-crisis-starting/. The conclusion from this article is:
The “Great Recession” has essentially only resulted in deleveraging of the financial sector. The overall levels of debt are still rising, thanks to a very modest deleveraging of the non-financial sector and a big releveraging of the government sector.
Was the only problem that the financial sector was too leveraged? If so, the Great Recession returned the markets to sane debt levels. If not, then the government releveraging has prevented the correction and deleveraging needed to put the credit crisis firmly behind us. We fear the latter may be closer to the truth and the credit crisis is only partially complete. The next major deleveraging will occur in the government sector.
Is this what widening sovereign CDS rates are telling us?
My answer: Yes!!
Tags: 10 yr yield, cds, deleverage, fannie, freddie, leverage, mortgages, private secotr debt, spreads, treasuries
Fixed Income/Bonds, Real Estate, Strategy/Allocation | Yaron Sadan | 
February 17, 2010 2:33 pm | 
Comments (0)
Bid to cover was still 2.67, direct bidders was at a recent high of 13%, which is interesting. Not sure why that is.
In the meantime, yields crept up towards the 3.7% mark. More interestingly, the credit default swaps (CDS) on 5 yr bonds is at 53 bps, which is up from 36 bps in January.
Gold – still hasn’t found its footing.
USD – definitely found some footing. Who wants to go short the dollar long risk into this weekend? No one.
Sovereigns – I heard one analyst talk about where there’s one roach (Dubai, Greece) there are probably others (Ukraine?, Ireland?, Spain?, Latvia?, Some country in South America?).
China – Industrial numbers came in about 1% better than expected, but I don’t thing the market cares. Currencies are the order of the day.
Banks – After their massive, Fed induced rally, I still can’t stand them. It’s all accounting games, Bernanke (and now Geithner) puts, and I don’t see how they’ll make money without transactions and the coming reigning in of leverage. Their business models now depend on NIM, which I think will soon be threatened. Also, we noted last week that there might be somewhat good news for CME as it stands to benefit from moving the CDS market onto exchanges. Turns out it’s also another negative for the banks as they stand to lose a few billion dollars in revenue (http://www.ifre.com/story.asp?sectioncode=730&storycode=318015). I have no position either way as of this writing, but I’m definitely not going long here. Good luck to John Paulson with the Citi offering on tap.
Stay tuned for an interesting weekend.
Tags: banks, cds, CME, Currency, dollar, gold, NIM, Paulson
Commodities/Futures, Currency, Fixed Income/Bonds, Strategy/Allocation | Yaron Sadan | December 11, 2009 12:05 pm | Comments (0)
I’m not sure what will come of this and what it means for CME or ICE at this stage, but the direction is obvious. CDS securities will start trading in standard form on some exchanges, with all the clearing, operations, etc. support that comes with it. Long-term it should be a positive, especially for firms worried about marking books in OTC securities. It also might be a big payday for CME and ICE (which has already started the process). At a P/E of roughly 30, neither is cheap, but might be worth keeping an eye on.
http://www.ft.com/cms/s/0/75922198-dfa1-11de-98ca-00144feab49a.html
This is the other article mentioned in Yra’s article from this morning: http://www.ft.com/cms/s/0/86a7ca6a-d794-11de-b578-00144feabdc0.html
I’m not the first to bring up the issue, but it doesn’t take away from its importance. When buying life insurance, the idea of insurable risk seems logical. An insurance company will only write a contract to a person with some interest in the life being insured (family member, business partner, etc.). Additionally, the company will only write the contract up to the amount of financial loss that might be incurred by that party. In this way, the market is actually limited by 1. the connections determined to include “interest” and 2. the amount of financial loss that might be incurred.
Without this limitation, insurance companies would write contracts for unlimited amounts (because they would want the premiums) and with no concern for connections (sell to as many people ON as many people as possible). The implications would be a market that has unlimited moral hazard (buyers of insurance would want to kill those on whom they have policies) and a market that is dependent on the insurance companies actually being able to pay of the unlimited policies. Sounds ridiculous in the life insurance market…and it is. It is no longer insurance, but rather, speculation.
The problem is that this is the way the CDS market works. Anyone can buy an insurance policy on the “life” of a company, without regard for insurable interest. Because there is no connection between contracts and insurable interest, the value outstanding of CDSs dwarfs the underlying companies. As long as companies don’t “die”, or die slowly, everyone is happy. The insurance companies that write the contracts (might be insurance companies like AIG, might be investment banks or others) are happy because they are collecting premiums. The buyers are making a speculative bet on the underlying (in reality they are also speculating on the viability of the contract writer), so they are satisfied as long as they feel they’ll be paid if the deed happens.
Unfortunately for the markets as a whole, the risk to the insurance companies continually grows at the same time as they seem more profitable. In the end, the speculation ends as expected: some companies fail, the insurance company can’t pay, leads to the buyer failing, and on and on. That is what we had with AIG/Bear/Lehman etc. and the government stepped in to pay the insurance companies liabilities. A shame, since the liabilities probably shouldn’t have been there at those sizes to begin with.
So what is the next step — I wouldn’t want to own CDS contracts right now, nor would I want to invest in anyone writing these contracts. Both parties will fail. In my estimation, the reform that will be coming will include some insurable interest clauses for generating new contracts. If regulators are smart, they will use a “principle-based” approach, rather than their traditional bias for “rule-based” approaches. In a principle based approach, intenet and context impact how decisions should be made. In a rule-based approach regulators specify what can and cannot be done. The problem with the latter is that once you specify, it leaves loopholes so that companies can work around it much easier. The danger is that any regulation might also limit all derivative markets in unexpected ways, but that is the risk we’ll have to take.
http://seekingalpha.com/article/99455-time-to-rethink-the-doctrine-of-insurable-interest-in-light-of-cds
Nov. 5 (Bloomberg) — Credit-default swap traders wagered
the most on debt of Italy, Spain and Deutsche Bank AG, according
to a Depository Trust & Clearing Corp. report that gives the
broadest data yet on the unregulated market.
http://www.bloomberg.com/apps/news?pid=20601087&sid=ajMvhbk5NDHg&refer=home
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