Conor's Weekly Roundup - CDS Primer

Conor Sen is coauthor of How Markets Really Work, and works in the investment industry in both risk analysis and fundamental analysis. He formerly worked in quantitative system development with Connors Capital. His opinions are solely his own, and do not represent those of his employers or this website. Information contained within is strictly for educational use and never constitutes investment advice.

"...cash, after millennia as one of mankind's most versatile and enduring technologies, looks set over the next 15 years or so finally to melt away into an electronic stream of ones and zeros." -The Economist

The gods, many of whom were molded out of gold by our ancestors, must have a sense of humor, as gold responded to last week's Economist by rising 2% to $682 to set a 9-month high. Gold is up another $5 overnight as I type this, and is set to make an all-time monthly closing high this Wednesday. Technology cuts two ways when it comes to money. On the one hand, its ability to facilitate money's purpose as a medium of exchange are incredible and hugely beneficial to the global economy. However, its power to debase a currency are equally incredible -- incredibly terrifying that is. Those who ask how high gold can go are asking the wrong question. If the Federal Reserve and our elected politicians continue on their current path, I have no doubt that gold will be $10,000, $100,000, $1 million, $1 billion or more per ounce within fifty years (merely rising at the rate it has for the past 35 years would get it to $50,000/oz in 50 years). After after, an ounce of gold was worth over one trillion marks in Germany in 1923. Gold had lay dormant from about mid-July until a couple weeks ago. Now that it has surged past $670, it once again pops to the top of the list of items I watch.

One of the reasons cited for gold's move last week was the continued meltdown in the subprime mortgage market. As a reminder, here were the levels the ABX indices (measures of the cost of mortgage backed securities insurance) hit two weeks ago:

"The A credit tranche widened from 98bps to 160bps in a week. The BBB tranche widened from 378bps to 503bps. The BBB- tranche widened from 629bps to 822bps."

What this means is that to insure a portfolio of A-rated mortgage backed securities (MBS), one would have had to pay 1.6%/year for full protection. For BBB-rated MBS, 5.03%. And 8.22% for (BBB minus)-rated. Fast-forward to today. For A-rated, 2.75%. For BBB-rated, 8.80%. And for (BBB minus)-rated, 12.50%. For comparison, the BBB and BBB- tranches were around 1.2% and 2.2%, respectively, in late August. These are enormous moves. The cost of insurance has gone up anywhere from 7-10 fold in under six months. And for the first time, we are beginning to see the nuclear fallout in mortgage-land spread to related securities.

Hopefully the above is somewhat clear. We've entered into the world of credit default swaps (CDS), the mysterious realm of finance which has grown from a $1 trillion industry a few years ago to a $26 trillion industry today. Yes, trillion. This sounds scary, and rightfully so. Here is a brief explanation of the important aspects of CDS. Consider the price of Walmart 5-year CDS: 5bps. This means that the cost of insurance on Walmart's debt is 5bps/year (for debt that expires in 5 years). In other words, the market is thinking about the likelihood of Walmart missing a debt payment -- not very likely. And then it thinks about the collateral Walmart has in case it has to default on its debt. After all, in the mortgage case, if I can't pay my mortgage but by selling my house 100% of my mortgage can be recovered, then my lender can be made whole. After weighing all those factors, the market's price of insurance for Walmart is a meager 5bps/year ( 0.05%). There are two uses for this market. One, Walmart bondholders can buy insurance via the CDS market on Walmart's debt, so it can earn the yield on Walmart's debt and pay a small price to have its principal insured. Two, asset managers can bet on Walmart defaulting -- or more likely that 5bps spread moving up or down -- and can buy or sell insurance on an asset that it doesn't have. Walmart could theoretically have $1 billion worth of debt but $500 billion worth of CDS outstanding -- aren't modern markets lovely?

In a normal, "Newtonian" market, there's nothing wrong with $26 trillion in CDS outstanding -- after all, much of it is probably in very stable debt like Walmart and McDonald's which is unlikely to default. The issue is in a once-in-a-million economy, CDS can be devastating. Counterparty risk becomes a real threat. Since CDS doesn't exist on an exchange, much of the volume transfers through few hands -- namely the big banks like Goldman Sachs, JP Morgan, Morgan Stanley, and the like. Nobody on the outside knows how much CDS these banks hold and what kind of directional exposure they have. If hedge funds hold $100 billion of CDS protection and Morgan Stanley took the other side of the trade, if that $100 billion of debt defaulted with no recovery, Morgan Stanley has to pay $100 billion to those hedge funds. I highly doubt Morgan Stanley has $100 billion in loss reserves set aside. Should Morgan Stanley be unable to pay its debts, holders of Morgan Stanley CDS would then come into play -- and suppose Lehman Brothers is on the short end of $50 billion of Morgan Stanley CDS. You can see where this is going. It sounds absurd to say, but it's not inconceivable that a CDS domino effect could destroy the debt and credit markets as we know them.

In related news, CDS levels for most of the big banks widened by 5-10bps on Friday -- granted, at protection levels of 30bps/year, the market does not give too much credence to Morgan Stanley defaulting on its debt within the next five years. Still, CDS levels are something to keep an eye on -- unfortunately, very few people in the world have access to CDS markets, so the public typically remains in the dark until a crisis occurs. In the months and years ahead, CDS is sure to gain more of a foothold into asset markets, eventually making their way onto listed exchanges. The sooner the public gets more transparency into these "financial weapons of mass destruction" as Warren Buffett called them, the better.

For what it's worth, I think the ABX spreads have just about topped out, and would not be surprised if they narrowed early this week, spurring yet another market rally, likely with a corresponding dip in gold. The issue becomes whether we get any widening follow-through in other CDS markets, and what sort of impact these spread levels have on the housing market.

Conor