Credit Default Swaps – like Dr. Jekyll and Mr. Hyde

Credit default swaps (CDS) are an example of a financial instrument that spiraled out of control during the latest financial crisis. CDS were created as a defensive hedging vehicle that allowed the buyers of the swaps to gain insurance protection against credit defaults, and sellers of protection received a nice stream of payments at a time of very low yields in the marketplace. Take this practical idea and add in models that said certain firms could never go out of business (think Lehman Brothers), a very loose regulatory environment with no counterparty accountability, and now introduce it into a banking system that ran casino-like strategies on 25-to-1 leverage. Suddenly, this once innocent product is transformed into the Frankenstein of financial products that threatened to bring down the entire financial system. Indeed, massive losses on CDS were largely to blame for AIG needing a government bailout.

Despite the fact that CDS became one of the “financial weapons of mass destruction” that Warren Buffet warned of, monitoring CDS prices can be useful as an early warning detection system for the credit markets. We routinely monitor the price of protection in the credit default swap market as one measure of overall credit market health, and to try to assess how much default and system risk is being priced into the marketplace. The chart below, from Ned Davis Research, shows the price (in basis points) of buying credit protection on different high yield bond indices. As the line goes up the cost of protecting against default rises to compensate investors for the increased risk of defaults, and when the line goes down it’s just the opposite. After peaking during the height of the bear market, the price of protection has come down markedly and across most risk markets (including investment grade bonds, high yield bonds, emerging market bonds, etc) which we take as a very good sign for credit markets, implying that there is much less system-wide risk than there was a few months ago.

We continue to believe the evidence is building that a recovery is close at hand, but we also acknowledge that conditions are still fragile. Some say system risk has simply been postponed temporarily, and if so we would expect an early warning signal to come from this credit canary. I suppose the good and bad wrapped into one instrument make CDS a little like Dr. Jekyll and Mr. Hyde.

Chartsource: Ned Davis Research