IN THE weeks before Bear Stearns, a Wall Street bank, collapsed in March, nervous investors scanned not just its share price for a measure of its health, but the price of its credit-default swaps (CDSs), too. These once-obscure instruments, now widely enough followed that they have even earned a mention on an American TV crime series, clearly indicated that the firm’s days were numbered. The five-year CDS spread had more than doubled to 740 basis points (bps), meaning it cost $740,000 to insure $10m of its debt. The higher the spread, the greater the expectation of default.
Once again, CDS spreads on Wall Street banks are pushing higher, having fallen in March after the Federal Reserve extended emergency lending Reserve extended emergency lending facilities to them. Reportedly one firm, Morgan Stanley, is monitoring its own CDS spreads to assess the market’s perception of its corporate health; if they rise too high, it intends to cut back its lending. Whether the CDS market is accurately assessing the creditworthiness of Lehman Brothers, trading on August 20th at 376 bps, double the level in early May, will be the next test of its worth.
There are some who doubt whether the CDS market is a reliable barometer of financial health. Though its gross value has ballooned in size from $4 trillion in 2003 to over $62 trillion, many of the contracts written on individual companies are thinly traded, lack transparency, and are prone to wild swings.
Recent spikes in CDS spreads on the three largest Icelandic banks are a case in point. In July spreads on Kaupthing and Glitnir rose to levels 35% higher than those observed for Bear Stearns in the days before it was bought out, according to Fitch Solutions, part of the Fitch rating and risk group. But the panic subsided after they released second-quarter earnings. Insiders say CDSs are increasingly used for speculation as well as hedging, which creates distracting “noise” particularly when the markets are as fearful as they have been recently.
On the other hand, although CDS spreads may overshoot, they do not generally stay wrong for long. Moody’s, another rating agency, says that market-implied ratings, such as those provided by CDS spreads, tally loosely with credit ratings 80% of the time. What is more, CDS spreads frequently anticipate ratings changes. Fitch Solutions reckons that the CDS market has anticipated over half of all observed ratings activities on CDS-traded entities as much as three months in advance. Though the magnitude of the moves may at times be unrealistic, the direction is usually at least as good a distress signal as the stockmarket.