Thursday, March 27, 2008 1 comments ++[ CLICK TO COMMENT ]++

Monolines: Historical CDS Chart

I am not too knowledgeable about the CDS (credit default swap) market and I feel that it is too illiquid and irrational at times. However, it is worth looking to see how the players in the CDS market perceive risk. Thanks to the author of the Accrued Interest blog, I was able to obtain the CDS charts for selected monolines and Berkshire Hathaway (as a side note, Accrued Interest is one of the best bond market blogs I have run across. There are good posts that explain the details of difficult-to-understand concepts.)

I wil be showing Berkshire Hathaway CDS spreads as a benchmark; while the monoline insurer spreads are my main interest. For those not familiar, a credit default swap is a derivative contract which allows the buyer of the CDS to swap an underlying credit instrument (say a bond of some company) when the company defaults. Essentially, the buyer of a CDS contract receives protection against default of a bond (or some other credit). In some sense, it is a very crude form of bond insurance without regulatory requirements. My understanding is that a sizeable chunk of the CDS market involves speculators who have no interest in owning the underlying credit instrument. In some cases, the CDS market is far larger than the underlying asset (i.e. more CDS contracts have been written than there are outstanding bonds). This is similar to some futures markets (if I'm not mistaken, the crude oil futures market is like that.)

Berkshire Hathaway is a good benchmark to evaluate the rest of the CDS spreads. Berkshire Hathaway is one of the few AAA-rated companies (note that the monoline insurer holding companies were never able to obtain AAA) and it has a lot of excess capital, which minimizes the probability of default.

(source: Bloomberg)

As you can see, there is clearly a lot of irrational behaviour in the CDS market. The CDS spread for Berkshire Hathaway quadrupled from 0.20% to 0.80% in the last 3 months, even though nothing materially adverse occurred at Berkshire Hathaway (I will note that Berkshire indicated that their future reinsurance earnings, which is a big chunk of their earnings these days, will be much lower. But I personally don't think that justifies the magnitude of the increase in the CDS spread). Investors are clearly bidding up the cost of the CDS, not because Berkshire is 4x more at risk of defaulting, but likely due to economic conditions.

The following chart plots the 5 year CDS spread over the last 6 months for Ambac, MBIA, and Assured Guaranty. Needless to say, it's an ugly chart for anyone long the monolines. The holding company CDS spreads as well as the insurance subsidiary spreads (if available) are shown. Here are some thoughts:

(source: Bloomberg)

The chart shows long-term CDS (5 yr) contracts and this is likely much better than the case for the short-term CDS (Jay Brown, CEO of MBIA, alluded to this a while ago in his letter to shareholders.) That is, the market thinks the monolines have a higher chance of going bankrupt sooner rather than later. If the market signal was correct, then the upside for investors from this is that if the monolines can get through their near-term problems, the long-term looks easier.

As Berkshire's CDS profile indicated, there has clearly been an uptrend in CDS spreads. This is further affirmed by the increasing CDS spreads for Assured Guaranty, which has largely avoided writing mortgage-related insurance since 2004 and is rated AAA (stable). There might also be a shift upwards in monoline insurer spreads since the existence of the whole industry is under threat. There is some attempt by municipal governments to avoid paying higher insurance premiums by pursuing alternatives. There is no way they are going to avoid higher premiums (since risk was somewhat mispriced all of this decade) but they are determined to get insurance using other means. Their alternatives include getting some other government entity to insure them, legislating lower premiums, or trying to improve their ratings by making the rating agencies use a single scale (which can result in some of the bigger "municipals" getting a AAA rating). All these industry threats clearly increase the risk and that is likely one big reason AGO's CDS spreads have increased.

As to be expected, the holding companies have higher spreads than the underlying insurance subsidiaries. The insightful observation is the fact that the insurance company spreads are near their highs whereas the holding company spreads are better than most of this year (except in February when they dipped). The increasing spreads for the insurance subsidiaries is not good news in my opinion. It means that the market is perceiving increasing risk with the core insurance company. As I have alluded to before, one can never be sure what is driving any of this. It is quite possible that the insurance company spreads are increasing because others are hedging their risk by buying CDS on the insurance company. If you are hedging then it is cleaner to buy CDS for the insurance company than the holding company (the reason is because a lot of non-insurance factors impact the holding company whereas the insurance company's risk is almost solely dependent on the insured assets.)

It's interesting to note that Ambac had a significantly higher spread late last year (compared to MBIA) but is very close to MBIA right now. Surprisingly, the stock market thinks the opposite. Ambac's stock price is down much further than MBIA right now. However, one should keep in mind that Ambac's dilutive effects were far worse than MBIA's (MBIA raised capital at better terms than Ambac). But Ambac's stock dropped much further even before any of the dilutive capital funding plans. Anyone following my posts on this blog would have seen how Ambac's and MBIA's fortunes have criss-crossed several times over the last year. Ignoring incompetent management (Ambac's has been far worse lately), the fate of MBIA and Ambac will come down to their exposure to CDO-squareds, HELOCs, and CESes (each monoline has differing profiles).

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1 Response to Monolines: Historical CDS Chart

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