No, this isn’t another article about how credit default swaps (CDS) have ruined or are going to ruin the economy. It’s about one of the nice side benefits of CDS: the habit they have of pointing out who is going to get into trouble next. And it has pretty Bloomberg charts!
As everyone probably knows by know, a CDS is insurance against default on a bond or bond-like security. If you think about it for a while, you will realize that this means the price of the CDS reflects the market expectation that the issuer will default.
The price of a credit default swap is referred to as its “spread,” and is denominated in basis points (bp), or one-hundredths of a percentage point. For example, right now a Citigroup CDS has a spread of 255.5 bp, or 2.555%. That means that, to insure $100 of Citigroup debt, you have to pay $2.555 per year.
CDS exist for various durations and on many different kinds of debt. If someone doesn’t specify the duration or the type of debt, he is usually referring to a 5-year CDS on senior debt. That means that the contract will be open for 5 years, during which one party (the insured) pays premiums and the other (the insurer) promises to pay off if Citigroup defaults. If there is no default within 5 years, the insurer gets to keep the premiums.
Look at it from the standpoint of the insurer. If Citi doesn’t default, I get $2.555 x 5 = $12.775. If Citi defaults immediately, I have to pay $100. That implies that I think there is about a 12.8% chance that Citi will default (ignoring the time value of money). Actually, my expectation of a default is actually somewhat higher, for a couple of reasons. First, if Citi defaults 4-1/2 years from now, I have to pay $100, but I’ve collected the $12.775 in the meantime (assume premiums are paid at the beginning of each year for simplicity), so my loss is only $87.225. Second, in any case I don’t have to pay the full $100; I only have to pay $100 minus the value of the security, which is unlikely to be zero even in the case of a bankruptcy. For example, Lehman bonds were only worth 9 cents on the dollar (so insurers had to pay out 91 cents), but Washington Mutual bonds were worth 57 cents. So my net loss will be lower, which means that my expectation of a default is higher. (The expectation is the money I expect to gain if there is no default, divided by the net amount I expect to lose if there is a default.)
Luckily, Bloomberg can calculate all of this for you, and right now they say the chance of a Citigroup default in the next 5 years is 16.2%. (That’s using a recovery rate of 40 cents on the dollar, but you can type in whatever rate you want.) You can see the valuation on the right side of the screen below.
OK, that’s interesting, but why call credit default swaps heralds of doom? Because CDS have shown the ability to identify what financial institutions (or countries) are going to get into trouble next. When the market starts getting nervous about a company and thinks it is more likely to default, insurance on that company’s debt starts getting more expensive. And this tends to happen before you start reading about that company in the newspaper.
Here are a few examples, in which I compare CDS prices to my home-grown “mainstream media” indicator, which is when the first article appeared in the New York Times saying a company was in danger of failure (as opposed to just taking writedowns along with every other bank). This is not scientific, because really you would want to compare the company’s CDS curve to an index of other companies in the industry to separate out sector-wide trends, but you get the point.
This is the chart of Bear Stearns’s CDS. Note that the price started climbing steeply in late February.The first Times article about Bear Stearns’s troubles was published on March 11, referring to the plunge in the stock price the previous day.
This is AIG. It looks like an instantaneous spike in mid-September, but the price had been climbing steadily, from double digits in May to 300 bp in mid-August to 430 bp on September 4. The first Times article appeared on September 12, again describing events on September 11. By September 10, however, CDS spreads were already up to 517 bp.
And this is Iceland. In the middle of 2007, Iceland’s CDS were priced below 10 bp. They spent most of July and August this year in the high 200s, passed 300 in mid-September, and reached 395 bp on Friday, September 26. Iceland only reached the attention of the mainstream media on Monday, September 29 (Times article the next day, in which Iceland barely got a mention).
So whose CDS spreads are climbing now? That will have to wait for another, or several other, posts.
Update: Felix Salmon says that CDS spreads are no longer accurate predictors of defaults. Maybe he’s right.