Some asset-backed dealers in the U.S. are starting to cover short credit-default swap positions on asset-backed collateralized debt obligations on the view the CDS spreads will be tighter than the cash underlying by as early as 2007.
Sellers of protection outnumber buyers of protection about two to one and CDS CDO spreads are wide to cash about 20-40 basis points. One trading official noted, however, that naked shorting--in which participants sell CDS without holding the reference bond--is a high-risk game at any time. "People who are putting on the naked shorts have to be expert technical traders," said another. Structured credit issuance, for example, can also affect spreads.
Dealers have sold credit protection on the CDOs because year-end widening in the cash market has become an annual phenomenon in the past couple of years. Although the reasons for this seasonal widening have never been pinned down, some players believe the advent of CDS on CDOs might have the effect of muting the expected widening, catching off guard those taking huge bets on the traditional move.
