Monday, September 15, 2008

CDS: the next big thing

How big are the Credit Default Swap haircuts going to be? Well, you can't say, because it's Over The Counter (as opposed to exchange listed). The market is a negotiated one (as opposed to an advertised one), and with the basis as volatile as it is, nobody commits a real price until they're ready to deal, because fair value is very much a moving target.

In fact, with trades driven by necessity rather than value, "fair value" is basically a nice concept, but not necessarily where a trade will be done. When the market is Volatile (capital "V"), and so many underlying pieces have values contingent on so many unknowns, it can't be easy to know what anything is truly worth. Markets can price any amount of bad news. But nothing torments a market like uncertainty.

With regard to the CDS market, buyers of protection are probably, by and large, happy clams. But for every buyer, there is a seller, and they are the unhappy clams. How many clams will be lost when the trades are settled? It depends on..what things are worth. And we're not too sure about that. But if they lose enough clams, there'll be another round of protection sellers who are unhappy clams, because they sold protection on the first bunch of clams.

It's a reactionary, defensive, back-against-the-wall kind of thing. One might say that it seems as if capitalism itself were under some sort of attack, if one had a poetic bent.

Today was not a good day in the market. It's never good when the stock market closes on its lows. It's really not good when the lows it closed on were the result of a single-session decline that is larger than all but the one between 9/11 and 9/17, 2001.

There we go with the terrorism theme again. Just keeps rearing its ugly head. It's that time of year. Financials crumbling like clockwork. Sworn enemies with mega-tons of cash, and world markets now connected by networks, arbitrage, and funky securities called "derivatives." But I digress.

Where was I...oh, yes. Not a good day. Closed on the lows. If this were just a bad day, someone could announce a merger, or the Fed could make some comments about interest rates, or something, to calm the markets and assuage fears. But what can the Fed say now? "We'll loosen up money?" That's all they've been doing all summer. That's not going to restore anyone's confidence.

And this is no ordinary bad day. This is, according to the statisticians, the worst day in years, by one measure. But the measure doesn't communicate the context: this is also one of maybe a half-dozen really, really bad days in a really bad year. And the professionals are walking around saying really unprofessional things like, "we don't know what to do, we've never been here before," and, "we have no idea what the CDS market will do." There's a very large "herd" contingent in this business; people studying one another from the corner of their eyes, trying to anticipate the other guy's next move. True leadership is rare, indeed.
This is the bad side of leverage, everyone's figured that out by now. And of course, everyone in the game was supposed to know better. Leverage is marvelous in a liquid, transparent market. But tip an inverted pyramid a bit too much, and....

So, the next thing we need to get our heads around is the CDS liability. The non-bank CDS liability. Banks have had to attempt to value these securities and taken huge writedowns associated with them. But hedge funds, who very often hold the aggressive other side of the trade, haven't. At least, not publicly. Watch the hedge funds. Maybe they can dodge a bullet. But there won't be any bailout for them.
Wall Street has many sayings. One of them is, "Money always returns to its rightful owners." That's what happens in a credit contraction. All that money that came out of nowhere goes right back there again.


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