Pascal's Wager For The Neomarxist Generation (Or The Rampant Confusion Among Risk Traders)

Lately more and more investors have been asking the same question: why are traditional metrics of market stress and credit supply not indicative of what the market is doing? In particular, they look at the VIX index as well as 3 month LIBOR, which, last time around exploded when the market reached its post-Lehman lows in November. Why should it be different now, when the market reached a 12 year low last week and financial company CDS levels hit all time wides, yet both the VIX and LIBOR have barely budged?

It is gradually becoming evident that the primary culprit for this strange behavior is likely the government itself with its recent policy change to guarantee virtually all short-term markets, especially in credit (via its alphabet soup of recently instated programs). And the market has responded appropriately by pushing sovereign risk to record highs, not only in the U.S., but in other systemically critical countries that have also taken on liability guarantee programs such as Germany and the U.K.

The transfer of default risk to the sovereign's balance sheet is a novel phenomenon (at least in capitalist societies) and over the past 3 months traders have been scratching their heads on how to trade this. The only logical trade that has emerged has been purchasing credit protection in sovereigns as spreads have tightened in companies that are either explicitly named as too big to fail or are in industries affiliated with them. At latest count, the largest guarantees were within the financial, insurance and automotive space. As the Moody's thesis plays out and any number of the upcoming companies with near $300 billion in cumulative debt accelerate their bankruptcy filings, it is inevitable that the government will increasingly assume more and more risk to prevent the wholesale closure of the U.S. economy and the loss of additional millions of jobs.

The problem with the sovereign CDS trade, as has been widely discussed in the media, is that unlike traditional corporate default protection, where the purchaser of protection gets paid a certain sum in the event of default, a U.S. default will likely lead to a capital markets shut down and any contractual relationships (such as credit default swaps) will likely have no value. As such purchasing US CDS is a dead end trade, with traders only betting on intraday or short-term gyrations they can trade in and out of, as other measures of expressing risk have collapsed. A good example is the drop in Bear Stearns CDS from 800bps on the Friday before JPM and the Fed "assumed" the bank, to a level in the 200s post the news. And as traders observe more and more sectors that are exhibiting increasing secular risk (i.e., homebuilders and REITs) they are concerned with purchasing outright protection in these names based on the fear that the administration may one day decide that Hovnanian or Boston Properties is the next too big to fail company, thereby collapsing CDS levels to an artificially and taxpayer-subsidized tight level.

This phenomenon is rapidly becoming global among developed countries, as sovereign spreads around the world bounce, leading to some peculiar side effects such as sovereign basis trades (where the CDS leg of a basis trade is the risk of the domicile country itself). But where does trade stack up on a relative basis?

Curiously, if one plots the ratio of Bank Liabilities as a % of a given sovereign's GDP to the CDS spread of that nation, an interesting trend emerges. As Kyle Bass pointed out, even with the recent dramatic widening in US CDS, the United States is the least troubled when observed via this type of relative risk analysis.

It seems that the market is yet again truly efficient, as it attributes by far the least relative risk to the United States (at least based on this metric). Not surprisingly, some countries which seem to have largely mispriced sovereign risk are France, Switzerland and Germany. At the moment when the levee breaks (in keeping with Kyle Bass' thinking), and the countries whose GDP simply can not sustain the debt load of their bank liabilities either through implicit guarantees or otherwise, the CDS spreads on some of the countries in the right side of the chart are likely to see substantial movement wider.

But, as pointed out earlier, the sovereign CDS trade is a dead end one, which presents the conclusion that market participants who want to express their appreciation of risk, either at the corporate or sovereign level, are likely more confused now than ever, in part due to the administration's constantly changing policy response to the deepening crisis and in part, in a modernist and inverted version of Pascal's wager, because, if ultimately proven correct, the result would be a financial armageddon which would render the instruments of expressing risk, among most other things, utterly worthless.