naked capitalism

The credit default swaps market suffers more dislocation with every passing day. It seems everyone and their uncle wants to buy protection, and with a shortage of sellers (despite the high prices), CDS spreads keep rising and rising, which in turn wreaks havoc with anyone who wants to raise funds right now (cash market prices are set in reference to CDS prices).

It’s a nasty feedback loop: the high CDS spreads reflect elevated concerns about default; the prices are magnified due to a supply/demand imbalance; those lead to unusually high borrowing costs for anyone so unfortunate as to need dough right now, which in turn will strain their finances. And the dearth of trading in the underlying cash bonds prevents arbitrage from correcting some of the distortion.

From the Financial Times:

In February, with the credit markets in turmoil, Highland Capital Management, one of the largest investors in the loans financing private equity buy-outs, decided to hedge its portfolio and bought $500m worth of credit insurance. “Risk management is an intense focus for us here,” Mark Okada, Highland’s co-founder explained at a conference call with investors.

Highland was not alone. Numerous banks and other hedge funds have sought downside protection as the market rout deepens. “When people are frightened, the first place they run is the credit default swap market,” says the head of debt capital markets at one leading Wall Street firm. But the soaring demand for insurance is creating a growing imbalance in the market that may have serious and adverse consequences in the wider financial market.

“The credit default swap market has become lopsided,” says Peter Fisher, co-head of fixed income at BlackRock Financial Management in New York. “It’s not deep and liquid the way we normally think of that — it’s more like an insurance market in which few want to write insurance and many want to buy.”

There is good reason for demand to take off as concerns grow that there is likely to be worse to come both in the credit markets and in the real economy. Companies with lower credit ratings have issued more debt than ever before, and in past cycles almost 37 per cent of CCC-rated paper default within three years.

Already, a growing proportion of borrowers are trading at stressed levels in the cash market, or at 1,000 basis points above Treasuries, according to Blackstone. In December, only 8 per cent of the total market was trading at those levels but by February the number had risen to 21 per cent.

At the same time, there are problems on the supply side. Many companies who used to sell insurance have left the market, including AIG as well as monolines such as MBIA.

That in turn means that prices may reflect the technical imbalance of supply and demand more than the fundamental prospects of individual firms. “Trading has become thin and volatile,” says Jack Yang, a partner with Highland.

Indeed, the price for insurance on many firms suggests that market operators believe they will default in a matter of months. But is that because they are desperately troubled or because there are many more potential buyers of insurance than sellers? However unreal the prices may be, the fear is that they can still have an impact in the real world.

For example, consider Residential Capital, the mortgage finance unit of GMAC, which was founded to help people borrow to buy General Motors’ cars. Currently, the credit default swap market trades at levels that suggest ResCap will soon default.

In spite of the fact that GMAC still has billions of unused credit lines and unencumbered assets, both GMAC and ResCap have faced ratings downgrades four times in recent months as the price of protection has soared.

Ratings agencies are influenced by the CDS market, with each feeding on the other: ratings downgrades lead to higher insurance prices, which means the cost of funding rises, leading to more strain on the balance sheet and subsequently more ratings downgrades.

Rising funding costs means higher lending charges, which in turn means that General Motors can sell fewer cars. Analysts expect the volume of car sales to be far lower this year than last.

GMAC’s controlling parent, Cerberus, has injected billions of cash into the company. It has tendered for its bonds in a show of confidence that briefly buoyed the price, although the bonds are now at pre-offer levels. It has also pledged the proceeds of the GMAC unit, which is in the hospitality business to support Rescap. It is, as one investor noted, “burning the house to sell the furniture”.

Even so, ResCap bonds dropped as the overall market strengthened on Tuesday.

In a normal world or in a world where the derivative is closely tied to the underlying cash security, if the price of the derivative became utterly divorced, market operators would step in to trade away the difference, Mr Fisher adds.

But volumes in the credit derivatives market exploded precisely because most of the bonds hardly trade at all. At Goldman Sachs, for example, for every three dollars of trading in bonds, the firm trades $97 in credit default swaps.