As many readers may know, when credit default swaps trade on an “upfront” basis, meaning a premium has to be paid immediately for the contract to be effective, when the risk of default is perceived to be high.
Also note in this case that the upfront payment applies to GE Capital, which is NOT the same as GE parent. And the article explains that other factors may be adding to pressure on CDS prices. However, given the size of GE’s financial operations, this does not speak well to the odds of GE pulling itself out of this mess anytime soon. And the market pricing stands in sharp contrast with the AAA rating on GE Capital.
From MarketWatch (hat tip reader John):
The cost of insuring against a default by General Electric’s financial-services unit jumped to distressed levels Monday on concern about a potential credit-rating downgrade, brokers said.
Credit-default swaps on GE Capital traded 11% upfront on Monday, according to broker Phoenix Partners Group.
When contracts on credit-default swaps trade upfront, it means investors seeking protection against a default must pay fees immediately. These contracts usually require only annual payments, but when concerns reach extreme levels, sellers of protection demand money upfront as well….
Monday marked the first time that GE Capital CDS traded upfront….
GE Capital CDS prices may be surging because debt of the unit was probably included in many collateralized debt obligations, or CDOs, according to Tim Backshall, chief credit strategist at Credit Derivatives Research.
CDOs are structured products that hold mortgage-backed securities, corporate debt and other fixed-income securities. GE Capital debt may have been included in these vehicles because it was AAA rated but paid relatively high interest rates during the credit boom earlier this decade, Backshall explained.
Now that GE Capital is in danger of a downgrade, the dealers who set up these CDOs may be hedging themselves by buying CDS protection on the unit’s debt, he said
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What does it mean to be AAA and “high” default risk?
Serious question. I don’t understand.
Isn’t someone really wrong?
Click “brushes9” to hear Iris Dement,
“Easy Getting Harder Everyday”
“What does it mean to be AAA and “high default risk”… AIG
Here is the question I have been asking myself for a couple of months.
Assume that the economy continues to deteriorate at the current rate for another 6-9 months and then remains flat.
Would the hole in GE Capital then be sufficiently large to wreck the whole conglomerate? How much capital would the Group need to raise? If, on the other hand, GE Capital would be un-saveable and thus needing state intervention (like some of the banks), how would one go about separating GE Capital from the rest of the Group, if possible? Would owners have to be wiped out as part of that process?
Until I have satisfying answers to these questions, I would not endorse any of the buy-recommendations for GE that I have seen recently.
@anoymous “What does it mean to be AAA and “high” default risk?”
Any normal person would expect the creditrating to take into account an expectation of the future. Apparently, they do not.
The agency tested the ratings assigned to collateralised notes of Dutch RMBS transactions in a variety of scenarios in terms of potential mortgage defaults and house price declines. The analysis, in particular, considered Fitch’s expected scenario whereby mortgage defaults rose to 2.5% of transaction balances and nominal house prices fell by 15%, over the next three years. The results derived from Fitch’s study suggest that one quarter of the notes from each of the ‘BBB’ and ‘BB’-ranked notes would be downgraded in such circumstances, and on a very exceptional basis that some ‘A-‘ (A minus) ratings could also migrate downwards.
From: http://anotherfp.com/newsite/story.php?id=839
So, a “stress test” means they analyse whether a rating would be downgraded, if circumstances arise that may result in the rated company defaulting? You’d think this was incorporated in the current rating!
With apologies to Voltaire,
Sanity, like history, is a lie commonly agreed upon.
Sorry if this is a double-post.
With advance thanks for the patience of the other commenters, I have a serious question, too. Who is still selling CDSs? How would I find that out? And who is agreeing to accept the final risk, AIG-style?
It would be nice if the upfront payment on the swaps represented fear amongst investors that the government intended to void the trade of unsecured CDS as against public policy, (seeing as how they’re little more than wager-contracts and all..) but I seriously doubt that’s got anything to do with it.
Correct me if I’m wrong, but doesn’t the issue of CDS create the same moral hazards that arise from selling life-insurance policies on strangers? Whereas some people would, and have, killed others to cash in on life-insurance policies- the law requires the purchaser of the insurance policy to have an insurable interest in the life of the CQV (i.e. a greater interest in the CQV being alive than dead, such as a close family tie or a partnership/dependancy relationship) Absent the insurable interest, life insurance contracts are little more than bounties.
For some reason I’ve yet to discern, CDS aren’t considered Insurance policies so they aren’t subject to the same requirement. Yet as in the case of the slayer’s incentive above, a morally bereft corporate exec could make far more buying swaps on his company’s debt and then driving the company into the ground than he would ever make if successful- seems like an easy choice to me.
I wouldnt get as excited about the CDS trading upfront… the convention in the market is once CDS spreads approach 1000bps, CDS starts trading upfront + 500bps (essentially the upfront amount is the difference between actual spread and 500bps times the risky duration).
Instead, what’s interesting is that current spreads imply a 50% probability of default over the next 5 years. And that’s for a AAA company.
The rest is covered here:
http://www.acredittrader.com/?p=14