Credit Default Indexes: Frankenstein’s Monster?

Bloomberg writers Neil Unmack and Sarah Mulholland do a nice survey of viewpoints (Swaps Tied to Losses Became `Frankenstein’s Monster’) on the problems in relating credit default swaps, indexes and cash markets.

A telling quotation comes from Kevin Gould, the head of data products and analytics at Markit, the source of various indexes.  As expected he provides a defense for the product:

The ABX index has brought greater transparency to the
market.  Without it there would have been a
number of market participants that would not have been aware of
the levels of distress some of their assets were under.

Fair enough.  But Gould also states, (Markit’s) "indexes should be used as a tool to gauge the
direction of credit markets, not necessarily to value the
underlying assets."

Now they tell us!

Many believe that the (very real) credit problems have been exacerbated by faulty government regulation that does exactly what Gould says we should not do.

The Bloomberg Take

Anyone who wants to read all perspectives should check out the entire article.  Mainstream media has given scant attention to this theme.  Meanwhile, this segment captures the spirit of the article:

`Totally Uncorrelated’    

The latest version for AAA rated subprime mortgage bonds
slumped by 43 percent since it began trading in August,
according to Markit, as rising U.S. home loan delinquencies
triggered a surge in the cost of credit-default swaps. That
implies a 53 percent loss on the underlying mortgages, according
to Schultz [head of asset backed bond research at Wachovia], almost four times the 13.75 percent rate predicted
by Wachovia.    

The cost to protect $10 million of AAA commercial mortgage
securities jumped 10-fold during one six-month period to
$100,000 a year, based on the first CMBX index from Markit. That
implies about 13 percent losses on the underlying loans, more
than four times the 2.8 percent forecast in the event of a
recession by JPMorgan Chase & Co. analyst Alan Todd in New York.    

“ABX, CMBX, any kind of X you like, are totally
uncorrelated to any kind of underlying market,” Swiss Re’s
Aigrain said at the Dubai conference.

Market Breakdown

The difficulty in using these indexes comes from the inability to arbitrage the widely perceived discrepancies.  Brad De Long raises the question of how to make money from this.  We examined the problem a few months ago in this post.

Anyone with a good answer to De Long’s question can both make a profit and improve market efficiency.

Thanks to Gary D. Smith for pointing out this story, which seemed to get little attention today.



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  • Bo April 16, 2008  

    Great analysis! This is like a commodity future market with no underline cash market. So it becomes a pure gamble where greed/fear could push prices to total absurdity.

  • DH@TH April 16, 2008  

    Banks’ new tool to deal with counterparty ris
    Rudimentary and idiosyncratic versions of these so-called contingent credit default swaps (CCDS) have existed for five years, but they have been rarely traded due to high costs, low liquidity and limited scope.
    But now there are high hopes that a revamped version of CCDS, which will bear the formal blessing of the International Swaps and Derivatives Association, will be more successful when it is released in two to three months’ time.
    Counterparty risk has become a particular concern in the markets for interest rate, currency, and commodity swaps – because these trades are not always backed by collateral, leaving banks vulnerable to sudden losses if counterparties collapse.
    he new CCDS was developed to target these institutions. Some banks have already started doing deals using a rough and ready version of the forthcoming standardised documentation.
    Trading volumes are thought to remain relatively small but, according to Bill Mertens, head of CCDS at Icap, the interdealer broker, demand has started to grow.
    “We’re constantly looking for the [point where growth] explodes. That may happen shortly,” he says.
    Unlike in a normal credit default swap, where the notional risk that is hedged is defined at the outset of the contract, each CCDS is linked to a second derivative, so the risk being hedged varies over time according to market movements in the underlying transaction. That means these contracts can be used to protect or lock in mark-to-market gains on the values of derivative contracts, as well as to protect dealers against counterparty risk.
    But dealers are sceptical that the instrument will take off, particularly where more liquid, if imperfect hedges are available, for example through more traditional CDS. GFI, a rival interdealer broker to Icap, abandoned CCDS last year because of a lack of interest, though it said it would re-enter the market if demand picked up.
    One counterparty risk officer at a leading European bank called CCDS “a product with nowhere to go”.

  • Lyon April 16, 2008  

    Found this blog on this AM. I think it’s great.

  • Lyon April 16, 2008  

    Found this blog on Real Clear Markets this morning. Excellent.

  • John April 17, 2008  

    I must appreciate the way you have analyzed the situation. Great work done.