The CDS Market: Causing Confusion or Offering Solutions?

In March, price-makers in the credit default swap market were demanding an upfront premium, over and above a 450-525 basis points spread, to cover default risk on GE Capital, the finance arm of General Electric (GE). This week, GE Capital’s CDS prices are in the 200-220 bps range, and no cash payments are being demanded or offered. A prominent issuer of daily CDS bulletins clarified that the sharp decline in perceptions of GE Capital risk “is a direct result of GE pre-funding 90% of its long term debt through 2010 and extending its commitment to its finance unit to five years from three.”

But in a debt market struggling to rationalize credit spreads, traders were wondering whether the entire CDS matrix was simply following the optimistic leads emanating from the equity markets? “How else can you justify 100-300% shifts in risk premium over a 6-month period?” a Wall Street bond specialist asked rhetorically in a recent CNBC interview. “Should we be ignoring CDS quotes altogether?”

Given that a minimum of US$187 billion (notional value) of single-name new CDS trades were executed last week and that thrice that amount was recorded in index-linked transactions, it is difficult to ignore the CDS market, regardless of the skepticism governing the pricing criteria in use. But it is pertinent to point out that, in this writer’s view, the dramatic reduction in the cost of risk has brought spreads down to unsustainable levels, particularly when the outlook for both global and U.S. growth remains uncertain. In fact, if CDS prices on sovereign risks were any guide, emerging market enthusiasts may well make a credible case to aggressively add on to long positions (EEM), despite the impressive 2009 gains in equities and bonds to date.

Five-year CDS prices for Russia and Indonesia have narrowed by 600 and 500 bps respectively since the start of this year. Argentina, which is due to announce another restructuring (post-default) of its foreign borrowings, is being quoted at 1,050 bps, down from a high of 3,950 bps in December 2008.

Interestingly, going by CDS spreads alone, there is little to chose between China (68 bps), Israel (100 bps) and Thailand (90 bps) on one hand and the UK (42 bps), the US (30 bps) and Japan (47 bps) on the other. CDS price-makers explain this phenomenon by pointing to the yield differentials on the underlying debt instruments, an explanation which begs the most fundamental of questions. Is the combination of the benchmark rate, the yield and the CDS spread, the “risk-free” rate for any particular debt issue, for all practical purposes?

In an obvious effort to improve the risk-profile on their lending portfolios, certain banks have been advocating that loan pricing incorporate CDS spreads for the borrower in addition to the usual credit spread (e,g, treasuries+credit spread/cost of funds+CDS price).

The logic of the move towards CDS-linked loans is firmly grounded in the belief that credit rating agencies like S&P and Moody’s (a) were too slow to react to the broad-based decline in credit quality last year and (b) are still incapable of responding in a timely manner to sudden swings in the business environment. “Banks have, as a rule, lost faith in their own loan pricing methodologies,” said a New York-based retail analyst. “The traditional cost-of-funds-based calculations have been damaged by the delinquency requirements, and the urge to buy protection will gather momentum as the assault on derivatives (by Washington lawmakers) subsides in coming months.”

Incidentally, on the subject of derivatives, lawmakers and, yes, bailouts, Bank of America (BAC), Citibank (C), Goldman Sachs (GS), JP Morgan (JPM), Morgan Stanley (MS) and Well Fargo (WFC) continue to be listed as “contributing banks” for the pricing of CDS indexes like CDX.NA.IG-13 and CDX.NA.HY-13 (markit.com). So, since the volume in indexed trades continues to breach new records, it is possible that some of your tax dollars are busy ramping up the credit risk insurance business!