Contagion Concerns From a 2007-08 CDS Trader

By Conor Sen  JUN 24, 2011 9:15 AM

Charts don't matter, macro data doesn't really matter, and until the contagion stops, valuation doesn't really matter either.


The last time we were in a similar situation, I was fortunate enough to get to trade ideas with Bennet Sedacca. His views on how the credit cycle were unfolding were spot-on, and he was one of too few people who had the intellectual ability, institutional freedom, and access to data to explain to the world what was happening. At the time I was back at my old hedge fund, where I was responsible for risk management, equity derivatives, and had some legacy responsibility for CDS/credit research thanks to picking up credit trading/research duties before we hired a guy to handle that full-time. I have traded and analyzed subprime housing and corporate credit derivatives, had access to real-time CDS data from 2006-2009 and spoke with the traders at the big banks who handled the flow, and for this reason feel compelled to do what I can to share my thoughts with the Minyanville community about what I'm seeing based on this experience.

The "Greece is Lehman" analogy is lazy, and while there are similarities there are important differences as well. What made the Lehman Brothers episode so scary was the fact that it was an important counterparty for a lot of financial institutions, its collapse occurred when all balance sheets from households to corporations and governments were overleveraged, when housing was still collapsing, and when asset valuations were generally higher. Nobody but the most extreme bears was prepared for it.

Since Lehman Brothers fell housing starts have fallen by a third. Non-farm payrolls have decreased by 5.7 million. Corporate balance sheets have strengthened significantly. Since the end of 2007 Apple (AAPL) has added about $50 billion of cash to its balance sheet. General Electric (GE) has added around $90 billion. Overall, nonfinancial corporate balance sheets are stronger than they've been since before the dot-com bust, as this Barclays chart shows.

One of the reasons for this is corporations are responding to their sterling performance by sitting on their cash instead of hiring and investing, or even returning capital to investors, like they would be in a normal cycle. This chart, shown by the brilliant Matt Busigin (@mbusigin), shows that hiring is lagging badly behind retail sales as companies to date have not had confidence in the recovery. The blue line represents the one-year change in retail sales and the red line represents the one-year change in non-farm payrolls.

Additionally, as this Bloomberg article notes, stocks are effectively at their cheapest level in 25 years. I recently wrote about how Berkshire Hathaway (BRK A) looks like a compelling investment at these levels (see Berkshire Hathaway's Operating Businesses Have a P/E Less Than 5). Technological innovation is leading to a resurgence in Silicon Valley. LinkedIn (LNKD) is one of my favorite ideas for this decade, a decade which my friend Professor Pinch and I think will be remembered more for the emerging "data economy" than problems with the sovereign debt of certain Mediterranean countries.

That being said, there are important similarities to Lehman as well. We've been talking about this Greece situation seemingly forever. Here's a Bloomberg article dated November, 2009, which is when the extent of the problem with Greece's debt and deficits really got on the radar of investors. One of the first pieces I wrote for Minyanville last summer was about European officials underestimating the extent of their problem (see Jean-Claude Trichet's Folly). And yet since that August 30, 2010 piece the S&P 500 has risen 22%. So who cares, right?

Well, between the devaluation of the Thai baht in July, 1997 and the summer 1998 peak of the S&P 500 a little over a year later the market increased by 31%, even as the Asian Financial Crisis dominoes were falling one by one. And then the S&P 500 fell by 20% over the following six weeks as Russia defaulted on its debt and Long Term Capital Management had its problem.

Since last August the Greece 2-year yield (my preferred measure for liquidity concerns -- the 10-year yield rises first and once it spreads to the 2-year it's game-over) has increased from 11.5% to over 28%. The Ireland 2-year yield has increased from 3.5% to over 13%. The Portugal 2-year yield has increased from 3.5% to over 14%. These countries are officially broken as far as the market is concerned. Spain and Italy have always represented the "firewall." Contagion can't be allowed to spread there. Maybe the market could handle the collapse of Bear Stearns and Lehman Brothers, but Morgan Stanley (MS) and Goldman Sachs (GS) were to be protected. It's the same with Spain and Italy. And Spain and Italy are dancing ever so precariously with contagion. The Spanish 10-year yield closed the other day above 5.6% for the first time during this crisis. Italy's yield is creeping back towards its old highs.

The Euro to Swiss Franc currency rate, one of the best measures of stress in the European banking system, closed today below 1.20, at 1.195, for the first time.

In addition, the German 2-year yield dropped from 1.48% to 1.37% in a single day today on contagion fears.

We've been getting these panic moves every three to four months since the beginning of 2010. Spreads for a country widen, EUR/CHF falls, stock markets fall, policymakers announce a bigger liquidity facility or do something else to regain market confidence, spreads back off a bit, and stocks go on their merry way. But the spreads and yields never fall back to their prior levels. EUR/CHF never bounces back as high. It's a problem Europe could fix by having Germany and France write a big check and then letting some of the PIIGS countries devalue their currencies or leave the eurozone, but so far they have been unwilling to do that. And we're running out of time.

We know about the interlinked exposure that European governments and banks have with each other. We have some idea about the amount of sovereign debt they hold. We have no idea about how much debt banks hold of other banks. This is where the Lehman parallels seem to fit. Greece is not an important counterparty to the European banking system, but if Greece restructures its debt or defaults then banks will take impairments, which will threaten their already meager capital levels. Immediately some of these banks will be more or less insolvent. If that happens there will be a general distrust of many banks in Europe just like there was in the US after Lehman fell. Banks will horde pristine collateral and repo markets will dry up. Leverage will have to come down which means forced asset sales into a market that will shun risk. The solvency of the European banking system will be a concern, which is a big problem for Americans since 39%, or $620 billion, of prime money market fund assets are in unsecured European bank debt, as Bank of America pointed out last week.

Why haven't banks sold all of this debt? Assuming there's a bigger sucker somewhere, of course, whether that be in Asia or elsewhere. Well, during the credit crisis and since banks moved assets from their "assets for sale" bucket where they were marked to market, to their "held to maturity" bucket where they only need to recognize losses if cash flows are threatened. And as this Citigroup (C) piece on accounting for a rescheduling/restructuring of sovereign debt notes, if banks sell securities from their "held to maturity" bucket they are impacting by "tainting rules" which state that other assets from their "held to maturity" bucket must move back to their "assets for sale" bucket, which means marking to market again.

So they're not going to sell sovereign debt until they can't. If they want to reduce risk they'll have to sell other correlated assets -- which could be anything from corporate credit in Europe and the US to equity futures to currencies.

My experience in 2007-08 taught me that in credit contagions understanding these dynamics is all that matters. Charts don't matter, macro data doesn't really matter, and until the contagion stops valuation doesn't really matter either. A $1 bill could trade for 70 cents if firms need to raise capital.

That being said, in December, 2008, the S&P 500 recovered to make a new high for the year. All of the losses from the Russian default and LTCM were made back and then some. This episode may very well be the same, with the economy and stock market valuations much more balanced than they were in 2008. But that doesn't mean that stocks can't fall 10-40% first if this gets out of hand. Be careful out there.
No positions in stocks mentioned.

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