Will Credit-Default-Swaps-Induced Distortions Continue?

A short piece in the Financial Times suggests that imbalances in the credit default swaps market are likely to continue, and those problems redound to the cash bond markets, distorting the prices at which companies can raise funds.

Admittedly, due to reduced anxiety in the funding markets, credit default swaps prices have generally improved. However, the lack of protection sellers (those willing to assume risks) means that CDS protection is generally more costly. That might seem a non-issue (is the CDS price now “wrong” or were earlier prices “wrong”) except that the CDS market is so much larger than cash bond markets that CDS prices now determine borrowing costs for corporate borrowers, so distortions in the CDS market have real-world impact. From an earlier Bloomberg story:

Credit trading models used by Wall Street have gone haywire, raising company borrowing costs even as Federal Reserve Chairman Ben S. Bernanke cuts interest rates.

General Electric Co. is one of five U.S. companies rated AAA by both Standard & Poor’s and Moody’s Investors Service, making its ability to repay debt unquestioned. Yet when the Fairfield, Connecticut-based firm sold 2.25 billion euros ($3.35 billion) of five-year bonds last week, its annual interest payment was $17 million higher than on a sale nine months ago.

Borrowers from investor Warren Buffett’s Berkshire Hathaway Inc. to Germany’s HeidelbergCement AG face the same predicament. Yields on $5.12 trillion of corporate bonds tracked by Merrill Lynch & Co. average 2.05 percentage points more than U.S. Treasuries, the most since at least 1997.

The higher costs are an unintended consequence of securities that allow investors to speculate on corporate creditworthiness. So-called correlation models used to value them have become unreliable in the fallout from the U.S. subprime mortgage crisis. Last month some showed the odds of a default by an investment- grade company spreading to others exceeded 100 percent — a mathematical impossibility, according to UBS AG.

“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of HeidelbergCement in Heidelberg, Germany, the country’s biggest cement maker. “Given what these spreads imply about defaults, we should be in a deep depression, and we are not.”

This Financial Times article explains why seeming mispricings of this sort are likely to persist:

Is something wrong in credit markets? A simple look at the risk premiums, or spreads, on cash bonds and those on credit derivatives shows a heightened dislocation has developed since last summer, says Geraud Charpin at UBS.

The market, he says, has become polarised between buyers of risk that focus on new corporate issues (cash bonds) and sellers of risk that focus on credit default swaps (CDS), the derivatives that provide a kind of insurance against non-payment of corporate debt.

“In cash bonds, companies [that wish to borrow money] provide an offset to investors [who wish to lend]. This allows an equilibrium between supply and demand to form. In CDS, the lack of supply side creates a major imbalance, which increases volatility.”

The problem is that complex investments known as synthetic collateralised debt obligations previously acted as big buyers of credit risk. But these products have withered and left the CDS market dominated by people who want to sell credit risk (go short, or buy protection) when things look bad, or switch to buying back credit risk to cover their shorts when the outlook improves.

“Until the synthetic CDO market re-emerges, the CDS market might be doomed to heightened volatility, moving above cash levels in bear runs (everyone buying protection) and below in bull runs (everyone covering shorts), while volatility of cash spreads will be tamed by supply/demand forces.”