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When Will We Know?

April 1, 2008

Reporter: But now I’m asking you: When will we know?
Henry Hurt: Blackout lasts for 3 minutes. If they’re not back in 4, we’ll know.
Apollo 13

When will we know that the credit crisis is over? One way to tell will be by looking at the market for credit derivatives. Credit default swaps (CDSs) permit investors to buy or sell insurance against the event that a specific company defaults (or more generally, experiences a “credit event”). The buyer of insurance pays a quarterly or semiannual premiums to the seller. In return, the seller promises in the event of default to pay the buyer the loss in bond value due to default. When CDS premiums are high, it is a sign that investors are worried about a default.

One of the striking features of the credit crisis has been a surge in CDS premiums for financial institutions. This is not surprising, since there seems to be a very real fear that a large bank will fail. CDS premiums are quoted to make them comparable to bond yields. For example, suppose you see a CDS premium of 100 basis points (one percentage point of bond par value). This is an annual premium, so if you had bought a bond yielding 8% and bought the default swap, your net yield if there is no default would be 7% (8% less the CDS premium). As long as the issuer of the CDS did not default, your position would be risk free.

What has happened to CDS premiums? Judge for yourself by looking at the accompanying graphs.

cdsfinancialsThe first graph shows 5-year CDS premiums for four very large and very important financial firms. You can see that these premium are high by historical standards and they have not nearly returned to pre-crisis levels. The peaks were reached in the middle of March, around the time (March 14) of the Bear Stearns rescue. If the government would not allow Bear Stearns to fail, it will not allow any of these firms to fail. Fannie Mae is particularly interesting because it is a government sponsored enterprise that is in the business of buying high-quality mortgages and reselling them with default insurance. Fannie Mae was created by congress and is to some extent controlled by congress. Its debt is not explicitly insured by the government, however. Fannie Mae CDS premiums are the lowest on the graph. You can see that CDS premiums are still high, but not as high as during the intense period of mid-March.

cdscorporatesThe second graph shows CDS premiums for IBM and General Motors. The financial world has for some time contemplated GM’s default, and that fact is obvious from the graph. IBM by contrast, is stable and relatively unaffected by the credit crisis.

cdusgovt

The third graph shows the oddest phenomenon of all. This is a plot of Fannie Mae’s CDS premiums and those for the US Government. Yes, you read that right. CDS premiums for Treasury bonds have risen during the crisis, reaching highs in the teens. To be honest I have no idea why the Treasury CDS premium would be so high, and I have no idea who would buy a Treasury bond CDS. (I’m not sure I completely trust the data I used, but I have seen data from Markit that shows something similar.) If the US government defaults, which financial institution is going to be around to make the insurance payment? If anyone has a good story for why the US Government CDS premium has risen, I would love to hear an explanation.

So to answer the original question: The crisis will be over when credit default swap (CDS) premiums return to “normal” levels. This does not mean that the recession will be over, or that housing prices will rebound and homeowners will have stopped defaulting, or that the dollar will again be worth one euro. The world has changed in a fundamental way and we will have to get used to new levels of asset prices.

It will take a while for everything to work out and for the system to settle down. However, once CDS premiums are low, we can infer that financial institutions are once again comfortable lending to one another. As it stands, there is still concern that a full-fledged financial meltdown could occur, with multiple bankruptcies by large financial institutions and a concomitant freeze in financial markets. This has to be one reason that CDS premiums are high for financial. The good news is that CDS quotes for financial firms do not resemble CDS quotes for General Motors. Yet.

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Categories: CDS, derivatives
  1. Siebeke, Roland
    August 7, 2008 at 3:06 pm

    I found Bob McDonald’s article “When will we know” using CDS premium levels as indicators very well written and convincing.

  2. Digvijay
    April 17, 2009 at 12:05 am

    The CDS premium graph for GM and IBM, shouldn’t that have IBM indicated by blue and GM by green.

  1. September 16, 2009 at 5:41 pm
  2. March 4, 2010 at 3:08 pm
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