Credit Default Swaps…and You
The Rude Awakening
Laguna Beach, California
Wednesday, March 14, 2007 ? Blind dating today's bond market…and other horrors,
? "SELL THE MORGATGE LENDERS!
? A fascinating divergence and a little bit more… Joel Bowman, reporting from afar… Below is a classic Fry column…any comments, questions or qualms, email me at aussiejoel@the-rude-awakening.com.
Enjoy…
Credit Default Swaps…and You
By Eric J. Fry If the bond market were a blind date, most of us would be looking for the exit from the moment the date began. This creature is boring, humorless and utterly unsexy. It obsesses over mind-numbing details like basis points and duration and yields-to-maturity. Borrrrring! But the bond market is smart…often much smarter than the stock market. For whatever reason, the bond market tends to ense inflexion points earlier and more acutely than the stock market. That's why it often pays to heed her subtle messages…and her not-so-subtle messages like: SELL THE MORTGAGE LENDERS. Most of the time, a given company's bond prices reveal about as much as a Victorian photograph. But occasionally, these oft-ignored securities provide some helpful hints about the financial health of given stock or stock market sector…or, at least, the collective perception of the financial health of given stock or stock market sector. That's why some seasoned professional investors keep an eye on bond pricing, even if they never intend to buy a bond. These investors would also keep a wary eye on the prices of credit default swaps (CDS) These fascinating little instruments are a kind of insurance policy against a bond default. The greater the perceived risk of default, the more expensive the insurance - i.e. the CDS - would become. Declining CDS prices, therefore, would indicate declining anxiety about a potential default, whereas rising CDS prices would indicate rising anxiety about a potential default. 
As such, CDS prices provide a very handy real-time picture of investor sentiment toward specific companies and industry groups. The chart above presents the CDS prices for three different bond issuers: the Russian government, Pulte Homes (NYSE: PHM) and Washington Mutual (NYSE: WM). The seemingly random squiggles on this chart offer a few very fascinating - and somewhat alarming - insights: 1) The almost imperceptible price jumps on the far right side of the graph illustrate the rising CDS prices for all three issuers since February 27th, the day the Dow dropped 416 points. This recent fear-induced jump in CDS prices is hardly surprising. But the fact that CDS prices have not jumped even more is also surprising…and a little unnerving. While it's true, for example, that the price of a CDS on Pulte Home's 10-year senior debt has jumped from 80 basis points to 120 in less than two months, the current CDS price remains below the high of 132 basis points set in the middle of last year. The CDS prices for Washington Mutual are also below prior highs. In other words, despite the rapidly imploding subprime market and the obviously deteriorating housing market, CDS buyers are displaying LESS anxiety than they did in 2005 and 2006, when conditions in the housing market were much less threatening. Investor anxiety toward the shares of homebuilders and lenders is increasing, but it has still not reached the sort of extreme fear and loathing that one would expect to see at a major market bottom. This relatively subdued reaction to the unfolding carnage in the mortgage-lending sector does not bode well for mortgage lending stocks…or for homebuilding stocks…or even for the rest of the stock market. 2) The chart above also depicts a fascinating divergence between CDS prices on Russian debt and those for Pulte Homes. Specifically, buying ten years of protection against a Russian default used to cost much more than buying ten years of protection against a Pulte Homes default. But that was as it should have been. The Russian government defaulted on its foreign debt in 1998. Amazingly, however, Russian CDS prices have fallen below those for Pulte Homes! In other words, CDS buyers consider a Pulte default more likely that a Russian default. Perhaps homebuilding stocks possess a bit more risk than most bottom-fishing investors would believe. Nevertheless, Pulte shares remain above their lows of last summer. That's despite the fact that Donald Tomnitz, CEO of homebuilder D R Horton, declared inelegantly last week, "I don't want to be too sophisticated here, but 2007 is going to suck, all 12 months of the calendar year." Several homebuilding CEOs have echoed Tomnitz' blunt declaration, more or less, as has Terry Wakefield, the head of the mortgage consulting firm that bears his name. "This is going to be a meltdown of unparalleled proportions," Wakefield predicts. "Billions will be lost." 
3) The recent jump in CDS prices reflects what Jim Grant dubs, "the recognition stage." Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance. As the chart below illustrates, CDS prices on Washington Mutual debt had been sliding for months, even though mortgage-lending horror stories had begun migrating to the front pages of the nation's newspapers. Instead of buying protection against visible risks, however, most investors shunned CDS and all other forms of protection. Instead of tip-toeing toward the exits, most investors rushed to find "the bottom" of the housing/mortgage-lending market. But now that companies like New Century are perishing, and the nation's largest banks and brokerage firms are warning of possible "mortgage-related charge-offs," demand for CDS protection is rife. Demand for put options on mortgage-lending stocks is also very robust. As a result, insurance ain't cheap. Then again, how often do you get the chance to buy fire insurance when you're house is already ablaze? If the bond market is as smart as she usually is, this inferno might blaze for a while longer still. --- Special Report --- Introducing what market insiders are calling… "The Only Stock You'll need to Own Over the next 10 Years" America's most famous investor has ALREADY made over $550 million holding this stock… and he's still got $839 million in shares… making it one of the biggest positions in his portfolio… Find Out More >> | 
