CDS Market Holding Up

Reuters reports that while the failure of Bear Stearns would have likely triggered a series of counterparty failures in the credit default swaps market had the Fed not come to the rescue, CDS securities have actually held up pretty well and remained relatively liquid even while other financial markets have had their challenges. To date, since the market for credit derivatives has come into being, there has not been a default from a major dealer or bank. Ironically, the Bear Stearns issues themselves may have helped bolster the CDS market since not only did the Fed prevent potential counterparty failures associated with Bear, but they also gave the impressions that other major derivative counterparties were too big to fail.

Other markets have not fared as well. Recent credit problems and housing related losses have reduced the flow of capital in the mortgage-backed security, CDO, auction-rate security, corporate bond, and preferred shares markets. On the other hand, liquidity in the CDS market, especially for 5-year duration securities, has been better than other markets, even though it too has experience less dealers, lower liquidity, and wider bid-ask spreads than normal. Yet, it is still functioning and allowing investors with illiquid corporate bond exposure to buy protection with credit derivatives.

Of interest for traders is that in some instances CDS securities have weakened ahead of stock prices, giving traders some clue as to what equities are a cause for concern. As an example, the CDS spreads for Bear Stearns widened by 10 times over two months last summer, significantly under-performing the stock and giving some insight into potential problems. Shortly near the end of the two month period, two Bear Stearns hedge funds collapsed from bad mortgage bets. The traders that were focused on credit risk hedged their exposure in the CDS market long before problems became evident to the equity market. Something worth noting as we hear of new activity in the credit derivative markets going forward.