CDS: It's Not About Credit

The FT has an excellent article explaining that corporate issuers are now being able to price new bonds off their illiquid secondary-market bond curves, rather than off their (wider) CDS curves. If you have real corporations borrowing real new money off real money investors, it seems, the credit crisis isn't quite as bad as the secondary-market prices might imply.

Alea is puzzled:

Apparently some "sophisticated" investors can't count. What would you prefer a cash bond that pays X or the same as synthetic bond that pays X+60 bp ?

For a 60bp premium, I'll take the synthetic. But then again, I don't mark to market. And the kind of people who buy synthetic bonds are exactly the kind of people who do mark to market - which means that they have to be worried about the deleveraging in the CDS market getting much worse before it gets better.

Besides, the arbitrage plays here aren't easy: they involve not only writing protection (that's the easy bit) but also shorting cash bonds. And with margin requirements where they are, and hedge funds' cost of capital spiking sharply, the cost of shorting those bonds could be very high indeed. Remember that's why the CDS market became so big in the first place: it's vastly easier to buy credit protection than it is to short a bond.

Basically, the market is in turmoil - which is why the Fed is stepping in with a large bump in the amount of liquidity it's providing to the banking system. The liquidity won't bring bond spreads and CDS spreads in line overnight, but it will help at the margin. In the mean time, prices are driven by the fact that there are a lot of forced sellers, and precious few willing buyers. They're not driven by investors who know more than you do about credit risk, pace Brad DeLong, who worries that "somebody knows something and wants to be your counterparty".

No one thinks there's an efficient market in credit right now, and even Andrew Lahde has stopped putting on new short positions because the cost of doing so is too high. A year ago, credit was too cheap. Now, it's too expensive. The big unknown is not whether spreads will tighten back in, but when.