In 1935 a much celebrated work of history appeared. It was written by the some-time editor of Vanity Fair, George Dangerfield, and was called The Strange Death of Liberal England.
In it, Dangerfield, in matchless prose, sought to explain the sudden attenuation of the Liberal Party as a serious force in British politics in the early years of the 20th century. After winning a landslide election in 1906 and embarking on a remarkable programme of political and social reform, the Liberal Party faded rapidly after the end of the Great War of 1914-1918.
A similar elegy might be written today for the global credit default swap market, although this being financial markets in the 21st century, its fall from grace has been much more rapid than that which the Liberal Party endured.
Less than a year ago, the CDS market was front page news — and not just in the financial press. They were seen as the most telling and purest indicator of the financial health of a firm, a country or even the global economy as a whole. Cash bonds, in contrast, were old hat; they responded more sluggishly and more technically to rapidly changing investor perceptions.
The market had grown rapidly in a short space of time and made fortunes for banks. The International Swaps and Derivatives Association proclaimed proudly the market’s burgeoning notional principal outstanding, which, at the height of the market stood at $62tr.
In the middle years of the decade, credit default swaps were the building blocks of synthetic structured credit instruments, a whole new investment class which offered returns significantly beyond cash instruments at, seemingly, little greater risk.
New issues were quoted against CDS prices, particularly in the euro denominated bond market which is less liquid and deep than the dollar bond market. They seemed the ideal benchmark, and borrowers nervously checked their current CDS prices before they got out of bed in the morning.
In the days leading up to the demise of Lehman last September, the investment bank’s CDS levels were quoted at length, and the closer to upfront territory they became, the more Lehman’s days seemed numbered.
Age of CDS passes
Nine months on, all is changed. At the recent Euromoney Global Borrowers and Investors conference in London, representatives of public sector and sovereign credits queued up to say that they no longer cared where their CDS prices were trading as they gave no meaningful clue as to where the credits might raise capital in wholesale markets.
Syndicate desks no longer quote new bond issues at a premium or discount to CDS. The market has become too idiosyncratic for this to be a worthwhile or illuminating procedure. Until very recently, the iTraxx grade investment indices traded at a heavy negative skew to the theoretical and, in the case of the Europe Index hit an all time wide of 30bp last November. It stayed negative for over six months, reflecting the extent of single name risk aversion and the extent to which the market had become unstuck.
Volumes and liquidity levels are well down from the market’s halcyon days. Banks have been forced to cut positions and post more collateral than they were wont to do. Trading desks have been reduced.
On top of all this, global CDS has got a really bad name for itself. The market has been blamed, not unfairly, as the instrument by which AIG blew itself up and then had to be saved with shards of taxpayer money before it blew up the entire financial system.
After Lehman’s collapse it was feared that collective exposure might be in the region of $400bn, which sent tremors of alarm through Wall Street and the City of London. In the event, the exposure was a lot less than this due to netting agreements, but the sheer opaqueness of the market alerted the concern of regulators.
New order needed
It is clear that the market will not survive as currently constituted. Industry professionals are agreed that a clearing house is needed, but they are worried that regulators will not stop there. A few months ago a US congressman suggested banning all CDS protection buying unless the counterparty owned the underlying credit, a measure which would have killed the market in the US.
Exchange traded CDS might lie round the corner. This will prove very unpopular with banks as it means much greater price visibility, and bankers are not always big fans of greater price visibility. But they know that after the events of 2008, they haven’t got a leg to stand on.
All this is a far cry from the heady days of CDS global dominance. But it might be a bit early to consign the market to a dusty corner yet.
The events of 2008 showed that more often than not the CDS markets got it right. Icelandic bankers protested loudly that the market was not only wrong but malign, manipulated by cynical traders. There was absolutely no reason for the Icelandic banks to trade in upfront territory, they said. Yet by the end of 2008 all three had collapsed and for more fundamental reasons than CDS prices.
Time and time again throughout the credit crisis, the extent to which various institutions were troubled was shown first and shown most clearly in the CDS market. Very rarely did the market get it wrong.
To this day, it remains the arena in which changes to a company are registered most quickly. Not only is this true of imminent bankruptcy or a failing business model, but also if an event is beneficial to the company’s credit. A CDS analyst noted last week that Arcelor-Mittal was trading at the equivalent of 1,500bp running before its recent restructuring, whereupon the CDS price collapsed and much more quickly than in the cash market.
It remains an ideal way for an investor to take an unfunded view of the credit of a firm or a sector, not to mention an ideal way to hedge exposure to cash market instruments. Volumes might be down, but they are still healthy.
Beautifully written though it is, Dangerfield’s thesis is now largely discredited. He claimed that the tumultuous events of late Edwardian England, like trade union militancy, the suffragette movement, the political crisis surrounding the People’s Budget and the increasing viciousness of the Irish Problem, presented problems for which British Liberalism was temperamentally and structurally unsuited to deal.
But he ends his account in 1914, when the Liberal Party still held government, and before the Great War and the still greater pressures that conflicted exerted. He left a lot out.
Similarly, any account of the demise of the global CDS market which ended in 2009 would be premature. There’s much history to go yet.