CDS "spread trades" and bubbles

A month or so ago there was some discussion of the "end of the world" trade. People have been trading credit default swaps (CDS) on the United States – these swaps are basically insurance against the possibility that the US defaults on its bonds – and to no one’s surprise the premium on this insurance has been going up lately. The trade in this product bewilders many for the simple reason that if the US were to default on its bonds, financial markets would be in such disarray that there is no reason to believe that any major investment bank or other seller of protection would be able to honor the insurance policy. That’s why CDS on the US are called the “end of the world” trade.

In response to the criticism of the trade, several financial commentators observed that these are in fact spread trades. (Here’s a particularly snarky example.) Because the premium is expected to go up, say from 0.7% to 0.8% over the period of a month, anyone who buys the contract today with the 0.7% premium will be due some collateral from the protection seller if the premium does in fact go up to 0.8%. (On the other hand, if the premium falls to 0.6%, the buyer of the contract will have to post collateral.)

Thus, someone who’s buying the CDS for a spread trade wants to receive collateral in case the premium on the contract goes up. One reason to do this would be to hedge: If you own Treasury bonds and are worried that interest rates will go up due to default risk and reduce the value of the bonds – the CDS can protect you from posting a mark-to-market loss on your balance sheet. But there’s a problem with this logic – interest rate swaps are a better way to protect against this possibility because they will compensate for a fall in the value of the Treasuries, whether or not the fall is due to a change in default risk. Furthermore the market in interest rate swaps is extremely deep, so the cost of entering into the interest rate swap is likely to be less than that of the CDS.

So what’s the other reason someone might buy a CDS on the US for a spread trade? To speculate on the movement of the CDS premium – if the premium moves as predicted, you can take advantage of the new premium by selling a contract at a higher premium than you are paying for a comparable insurance policy. Theoretically if there is a default requiring payment, you can simply pass on the payment that you receive from the bank that sold you protection. (Of course, this is the “end of the world” trade, so you’re probably thinking that if a default takes place, you may not get paid by the bank and you may not be able to honor your own obligations, but presumably this is such an apocalyptic scenario that it’s not really worth worrying about.)

I think the important question to ask is: What do spread trades on CDS on the US tell us about the market? They prove that there is a bubble in this CDS market.

People are trading something that they know has no fundamental value, in hopes of reaping short-term gains. Of course, the fact that the contract has no fundamental value means that someone will be caught at the top of the bubble, paying a high price for a valueless contract.

One phenomenon that supports this bubble is that, if the premium does rise, the value of the contract will go up and the buyer of the contract will benefit from short term accounting profits. The fact that everyone knows that this profit will disappear over the long-term, is a sign that these firms are “gambling for resurrection”. If they can make it through the short-term without declaring bankruptcy, they hope that longer-term investments or gambles will pay off allowing them to survive the crisis. On the other hand, they’re paying a premium today to preserve that possibility.

Who is selling the CDS on the US? Anyone with the balance sheet capacity to carry the interim losses that will have to be posted to the balance sheet if the premium goes up.

So, yes, it is true that “CDS on US government debt are spread products,” but this fact is itself a sign of how very, very sick our financial market are right now. It’s also proof positive that CDS are not always a good way to price default risk. The “end of the world” trade is a bubble and when it pops someone is sure to end up posting losses.