CDS markets - where's everyone hiding Thursday, December 06, 2007
Credit default swaps ("CDS") have been a huge growth market in recent years.
Conceived as a way of providing "insurance" against the default of a bond whereby the insured paid a premium to the insurer, these developed to provide payouts to fit particular circumstances eg downgrade of a bond; missed interest payments. The protection was usually linked to a reference asset (specific bond) and you had to exercise care that you chose the right one as often companies had many bonds in issue with different levels of seniority in the event of a default ie some would be paid out before others.
CDS also allowed greatly liquidity in the bond markets because a bank could agree to fund the issue of a corporate bond, whilst selling/hedging the credit risk.
But eventually these became the main way of trading credit risk naked ie no need to hold the bond as a CDS gave you the same exposures with less funds. If you thought the credit risk of a company would worsen you bought a CDS (short position), whereas if you thought the outlook was stable or set to improve you sold CDS (long position). This also avoided the messiness of having to physically trade and settle bonds.
Unfortunately, the markets have virtually dried up in these instruments, particularly in single name CDS (cover for particular company/bond). Its become very difficult to even get a bank to offer a price for a CDS, and where they do the spreads are large. The credit uncertainty is leaving people too scared to price the assets. More significantly, for holders of CDS positions is the challenge of marking the assets to market (valuing them to reflect what you could get for them if traded), as prices aren't readily available - mark to made-up/model price are used instead which will reflect normal market conditions. As such some portfolio values are likely to be "adrift" and hiding losses.
Its hard to tell when confidence will return and hence CDS markets will re-emerge but their absence marks a regression in investment techniques that can be used to generate returns.
posted by John Wilson @ 10:26 AM Permanent Link
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