Anyone Still Doesn't Think the CDS Market Doesn't Provide Any Signals?

I wrote an article recently pointing out that the CDS (credit default swap) market prices are almost completely useless. I ran into another article from Bloomberg pointing out the same material that was covered in the original post. Since I feel that this is an important issue that illustrates how market prices are not the pancea of reality, let me quote some of the points mentioned by Bloomberg.

General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor's and Moody's Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.

Borrowers from investor Warren Buffett's Berkshire Hathaway Inc. to Germany's HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.

It's one thing to argue that CDS of, say, Ambac is or is not misleading. I can see rational investors accepting the market prices for a default by Ambac because it is under severe stress. Yet, it's another thing to assume that AAA-rated GE's or Berkshire Hathaway's probability of default has gone up without any serious deterioration of business conditions.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent -- a mathematical impossibility, according to UBS AG.

``The credit-default swap market is completely distorting reality,'' said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country's biggest cement maker. ``Given what these spreads imply about defaults, we should be in a deep depression, and we are not.''

This would be all laughable (especially the probability of default for an investment-grade corporate going above 100%) except it is having a real impact on businesses out there. I'm not blaming anyone; I'm just pointing out that the CDS prices are becoming irrational.

As values of CDOs began to fall, banks that had sold swaps underlying the securities started to buy indexes based on them instead, a method of hedging their losses on portions of the CDOs they owned. The purchases are driving the cost of the contracts higher, raising the perception that company bonds tied to the swaps are suddenly riskier and leading investors to demand higher yields throughout the corporate debt market.

The Markit CDX North America Investment-Grade Index, a gauge of credit-default swaps on 125 companies from Wal-Mart Stores Inc. to Walt Disney Co., has more than doubled since the start of the year.

Similar to how I speculated that the ABX index may be falling because people are hedging subprime risks by shorting it, the CDX index is rising because banks (and others) who wrote CDS contracts are hedging by buying the index. Throw in illiquidity and inefficient flow of information in these derivative markets and you are bound to get huge increases and declines from these hedging actions.

Banks bought more contracts on indexes containing GE's swaps after CDO pricing models broke down, sending the so-called default correlation to more than 100 percent last month from 60 percent in July, according to research from Zurich-based UBS.

The programs, which computed the value of the highest-rated portions of CDOs, implied that all companies in the CDX index would default if just one did. Banks often hold these senior tranches after arranging the CDOs for investors.

Let me repeat an important element: "The programs...implied that all companies in the CDX index would default if just one did." That pretty much sums up the situation. I believe this is a problem with the ABX index as well. This is very important to monoline insurers. Taking some losses on a single insured asset versus taking a loss on all the assets is the difference between life and death for the monolines.

Some bears out there (Bill Ackman and Reggie Middletn in particular) have put out reports predicting massive losses for the monolines. Not just for one company but for literally all the companies. If you look into their estimates, you'll notice that they assume that there will be losses on every asset across the board. They point as evidence the fact that an index such as ABX, which is showing high likelihood of losses, is implying losses for every constituent of the index. Of course, this is complete nonsense for an insurer. The fact that something like an ABX index is down doesn't mean that every asset is going to default, let alone the insured asset. This is just as dumb as assuming that G.E. is going to default because the CDX index increased.

The mathematical breakdown is compounding the decline by creating a vicious circle. As the cost of the swaps on the CDX index increases, the models signal a greater risk of defaults, and vice versa. A bank holding $100 million of the highest-rated portion of a swap-based CDO now has to buy $60 million of swaps to maintain its hedge against losses, JPMorgan said. A year ago, it would have had to buy $10 million.

Throw in heavily leveraged hedge funds into the mix and you can see how there will be massive amounts of buying and selling just to maintain their hedges. I suspect that you will see wild swings in the derivatives markets as investors run into problems. A lot of these so-called hedges will end up hurting more than hedging anyone...