For reasons I don’t fully understand, credit default swaps seem to have a tendency
to gap out much further than spreads on the underlying bonds. That happened
in subprime mortgages, and it seems to be happening now with brokers. Caroline
Salas’s Bloomberg
story is long and not particularly easy to follow, but one can extract a
few datapoints. Let’s take Goldman Sachs, which has a very strong Aa3 credit
rating from Moody’s: Salas says that the prices of its credit default swaps
"equate to a Ba1 rating," whatever that means.
Then again, it’s hard to draw much of a bead on what those prices are:
Credit-default swaps tied to $10 million in bonds of Goldman Sachs, the world’s
most profitable securities firm, rose to a high of $125,000 yesterday, according
to Phoenix Partners. The default swaps traded at $69,000 today, Phoenix data
show.
Salas also gives no prices on Goldman bonds, so it’s unlear whether or by how
much they might have widened out. She does say that brokers in general are trading
at 125bp over Treasuries, up from 64bp over in January – but that doesn’t
sound like a distressed or even junk level to me.
I think the real lesson here is not that Merrill Lynch is "trading as
junk," as Salas’s headline would have it. Rather, it’s that the CDS market
exhibits a lot of volatility, for reasons which can be hard to pin
down.
Bonds from brokerage companies are pretty liquid things. If and when those
bonds start gapping out, I’ll start believing that something important is happening.
But it’s almost impossible to find a coherent signal amongst the noise of the
CDS market.