Tuesday, February 24, 2009

Credit Default Swaps

Credit default swaps (CDS) are contracts that allow for the transfer of credit risk. For example, let's say that a pension fund manager owned several million dollars worth of XYZ Corporation bonds. The manager thinks that the company may hit a rough patch and there is a risk that the company may not be able to pay off its debts. The manager could enter into a credit default swap in which he/she would pay a fixed amount of money to the seller in return for downside protection. If XYZ Corp. did indeed default, the manger's bonds would be worth much less, but the credit default swap would make up for most of the slide.

Of course, much like any useful tool, CDS can be mismanaged and lead to large losses. We will leave that for another discussion, for this post I want to focus on the current market for protection.

The above graph represent today's closing prices for protection on residential asset backed securities. The lower the price, the more expensive the protection. The indices are grouped by loan quality and securitization date (vintage). As you would expect, the higher rated indices are trading at higher prices. What is noteworthy is that 8 of the indices hit new lows today, indicating that risk appetite is weak.

The second graph represents prices for commercial mortgage backed securities. These indices work in the opposite fashion, the higher the level, the more expensive the protection. Three of these indices hit new highs today.

Although these prices are not perfect indicators of asset quality, they are some of the only resources available to market watchers. After all, there is only one bid.....the Federal Government.

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