Investors’ Markets versus Gamblers’ Markets
Before I get started on tonight’s piece, I thought I might apologize for a wrong prediction, lest I be confused with a famous guy that I sometimes get associated with. I was wrong that ABX.HE 07-2 would not get created. A number of the tranches priced significantly above a 500 bp yield, and so those lower rated tranches got sold at a dsicount to the par value of the securities. In the unlikely event that those securities get paid off at par, the buyers will be most happy indeed.
But onto tonight’s topic. Regarding credit default swaps, and their new cousins, ABX, CDX, LCDX, CMBX, etc… there are often more swaps trading than there are underlying cash obligations. What this implies is that most of the activity going on is not hedging and speculation facilitating hedging, but merely speculation/betting.
What this means is that in the short run, until the cash obligations underlying the default swap mature, there is little to keep the cash and derivative markets together. The swap spread could be a lot higher than the cash market spread, indicating fear, and a lot of players being willing to bet on partial or total default occurring. That’s where we are now. So, when I hear new lows on ABX.HE indexes, and some authoritative voice says that means many defaults are occurring in subprime mortgages, I take a breath and remind myself that it means that more players are betting on increased defaults and loss severity on subprime mortgages.
The opposite can happen too. Back in 2002, when I was a corporate bond manager, and default swaps were pretty new, I would not buy bonds where the cash spread was smaller then the swap spread, because that indicated a lot of players betting against the bonds in question. If someone holding a bond would sell and replace it with offering protection on a default swap, they would improve their yield, so when the swap spread was wider, it would often lead the bond spread wider as well. I would wait until the swap spread fell beneath the cash bond spread, and then I would pile in. Worked really well, and my brokers at the time thought I had this great sense of timing. Well, maybe I did, but it was analytical, not intuitive.
My main point for my readers: take the prices and yields from swap markets with a grain of salt, particularly on anything they imply to the real economy. For that, look at the spreads in the cash bond markets. Limited arbitrage aside, those spreads are more free from raw speculative frenzy.
One last note: almost all users of the bundled credit default swaps are speculators. They never hold the exact exposure as the swaps, and so the best of them cross-hedges his positions. So why did these get created? Wall Street saw a need to allow speculators to express bets that correspond to larger liquid composites in the cash bond markets. Individual tranches in structured bond deals below AAA are all very thin, and the ability to put a lot of money to work rapidly is limited as a result. But what if you could pair up additional shorts and longs to take on opposing risks, without them directly investing in the cash bonds? You would then have a swap market, and the spreads there would differ from the cash market depending on which side of the trade was more motivated: the side needing yield, or the side betting on default. It’s a big side bet, and hopefully both sides are well-capitalized, but who can really tell?
July 25th, 20076:53 am at
Hello David,
I think you make a great point about the difference between what the real impact on the economy may be during a massive de-leveraging event. I believe it is true that it may have little impact or indicate little in the short to intermediate term. However, as you know the level of leverage involved in the CDS market is immense. While it is true it may provide different info than the cash market. A large unwind of that leveraged market could cause ripple effects in the financial markets as investors’ aggregate risk preferences can shift from “high risk seekers” to “moderate or low risk seeker”. There are already market areas that are getting pummeled both institutional and retail investors. Just pull up the chart of most leveraged closed-end funds - really ugly.
While a major de-leveraging event would not necessarily indicate a softer economy, it does not mean that the event won’t be extremely violent. Ala 1987 and 1998, the gov’t efforts to prevent risk preferences from shifting could be successful. However, ala 1929 that is not a guarantee and IF risk preferences shift dramatically due to over-leveraged losses, then it would begin to impact the economy.