Friday, June 3, 2011

U.S. Bank CDS Rising, but Still Low

Last week, Rick wrote an entry describing how we’re watching closely for any signs of banking sector stress in Europe as they continue to wrestle with their debt crisis. We are also keeping close tabs on the U.S. financial sector, which is still one of the largest sectors in the S&P 500 Index despite all of the problems of the past few years.

Financials are the worst performing sector in the S&P so far this year, indicating that things still aren’t quite right there. The XLF Financial Sector ETF was off by -3.7% YTD through yesterday, while the S&P was up by 5.2%. And on Wednesday, which was a rough day for the market in general, Financials got hit especially hard as news broke that Goldman Sachs was dealt a subpoena under a new investigation into its mortgage securities business by the New York Attorney General. Investors may be rightfully wondering if the recent action in Financials is portending something ugly for the rest of the market, as it did in 2007.

While Financials’ equity market performance is troubling, the CDS market is telling a different story at the moment. CDS, or Credit Default Swaps, are used by hedge funds and other large investors essentially as a form of insurance. They purchase the contracts to hedge against the risk of default for specific companies. As the cost of CDS increases, it’s usually a negative signal that investors are suddenly clamoring for protection, driving the price higher.

The chart below shows an average of the CDS for 34 U.S. banks.  The line has crept a bit higher recently along with general volatility in the financial markets. But, it’s still lower than where it started the year. Also, since the chart goes back a couple of years it offers some perspective, illustrating that bank CDS is still well below levels reached last year and during the financial crisis of 2008. In short, we aren’t seeing anything alarming at this point in banking CDS.