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Friday, April 11, 2008


CDS market deterioration?

a couple of articles -- first yves smith passes on an anecdote.

I happened to meet with a hedge fund yesterday (unlevered, BTW) and it comments in passing were telling. They are seeing very large volumes of mortgage paper even though, this fund has not bought a single mortgage and expect that there is even more that would be offered if buyers were stepping forward. In addition, credit default swaps traders tell them that that market is in perilous shape. A great deal of the protection was written by hedge funds, who were typically levered. When they get into trouble, their problems will redound to the investment banks, both through their exposure as CDS counterparties and as lenders to failed hedge funds.

The fact that CDS traders are discussing such a grim viewpoint with people outside their firms (let's fact it, most businesspeople don't go around saying their product is about to implode) suggests that it is a common knowledge in the dealer community. I wonder if this topic is getting short shrift for a reason. The media has been known to overlook the foibles and failings of public figures until they are on the ropes. There may be similar self-censorship operating here, since the press probably does not want to be accused of fomenting panic.

then ben bittrolff looks more analytically at the pricing in the marketplace in the aftermath of further downgrades of several monolines.

i have no particular window onto the CDS market -- all my perspective comes secondhand. but i think this much is apparent: the federal reserve bank has gone to war in large part to protect the CDS market. there are certainly other, very good macro reasons for the fed to be cutting policy rates; but there is essentially no compelling macro reason to have stepped into the bear stearns situation, nor to have extended the envelope of de facto discount window protection to all primary dealers, except to have staved off the unwinding of this immensely important and extremely leveraged market in an intensely chaotic manner.

the question of the hour is whether or not the fed, in this new supercharged role -- one which not all of its advocates think appropriate, mind you -- can quell the fears of traders. and i have sincere doubts as to whether they can, because of the structure of the CDS market.

when bear was on the brink of failure, there was some intense speculation that the ibank was being pushed to its destruction by none other than the commercial banks which serviced it. after all, with banks badly needing collateral to take to the window, one of the ways they can obtain collateral is to see an ibank default. some opined that jpmorgan was not so much the savior of bear stearns as the fed drove a pile of collateral to jpmorgan for a bargain-basement price in an effort to shore up the commerical bank, which is the single largest player in the CDS market and heavily invested in the commercial and CRE loans that are only now starting to run into difficulty with the onset of recession.

by extending discount window protection to the major ibanks, however, the fed has less solved the problem than shoved the same incentives one layer further out into the shadow banking system -- now it is commercial and investment banks both who are incentivized to cut off the parties left just outside the fence, which is the hedge fund community. unlike the ibanks, no one will be making much of a case to salvage hedge funds in this environment. this isn't 1998 with one large firm in trouble; now, many funds are being squeezed and not all of them can be helped.

what's more, there looks to be a surefire trigger in the wings -- recession, and what it means for actual bankruptcies. after years of progressively easier corporate credit which kept weak companies in business and drove bankruptcies to all-time lows, the piper has come calling for his due. already we're seeing conspicuous bankruptices in the airlines.

sooner or later, a large bankruptcy with a massive presence in the CDS market is going to push a significant hedge fund player to insolvency and it will not be able to meet its claims. many other players will suddenly find that their CDS book is unbalanced -- and, in a high fear environment that expensively precludes going out and writing new contracts to rebalance, books will be balanced by forced sales, sending more hedge funds to the wall, and so it goes. the fed may be able to salvage the banks in such a scenario, but not without severe losses -- and they will be essentially powerless to prevent the unwind in the international hedge fund universe.

this scenario is why CDS spreads have widened and will persistently stay wide until either it becomes clear that the economy has traversed the recession of 2008 without a disaster unfolding in the CDS market -- or until the disaster actually does unfold.

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