The Crazy, Upside Down World of Credit Swaps

Why did credit default swaps on Morgan Stanley and Goldman Sachs rise today? The cost to insure Morgan Stanley's debt rose by 50 basis points to 480 while Goldman's cost rose by 40 basis points to 240. A Clusterstock headline screams "Morgan Stanley In Trouble Again." Heck, even Merrill Lynch, which received regulatory approval today to go ahead with its Bank of America merger, saw its credit defaults swaps go up by 20 basis points according to Reuters.

The higher the cost of the swaps, the more likely investors think the underlying company will default on its debt. Why are investors suddenly convinced (again) that the investment banks will fail?

Reuters cites an erroneous report from the American Bankers Association that said the banks would not be eligible for the new F.D.I.C. program that guarantees bank debt as a possible reason for their weak performance. This mistake was included in a downloadable Q&A on the Treasury's recapitalization plan yesterday. It was corrected on ABA's web site today.

It's hard to believe that many investors in the credit default swap market were misled by an association's backgrounder for the public.

It's true that the market tanked today, Ben Bernanke uttered more sobering words, and dismal economic data released this morning offered even more evidence that a long and painful recession lies ahead. That would explain why the share prices of Morgan and Goldman fell today. But their credit default swaps?

We've asked this many times during the recent weeks of turmoil, but we have to ask again. WTF?

It should be obvious now that the Treasury Department doesn't plan to have another Lehman Brothers on its hands. The government is now a major stakeholder of these firms, and in many ways it also still controls their fate. Would Paulson let Morgan Stanley go bankrupt? No. Will Bank of America back out on its planned acquisition of Merrill Lynch? Hell no.

So, what's this insight that the credit market has into the future of Goldman, Morgan, and Merrill?

Anyone?