CDS

The bloodbath in fin CDS is even worse than what is going on in equities. Bank of America is currently at the widest it has been in 2010.The latest rack is provided below, and the LTM 5 year Sr CDS spread is charted below. Yet the biggest bloodbath continues to take place in woefully underreserved HR Block, which is certainly not too big to fail, and which was about 30 bps wider on the day, now at 720/691. On the chart below, HRB's spread is on the right axis. Will the little tax preparer that almost could be the first casulaty that sets off the TARP 2 starter pistol?

First thing yesterday, when we first highlighted that CDS in mortgage names were blowing out, even as the moronic market was all giddy on JPM's earnings beat which was really a miss, we warned "be careful trading financial stocks: JPM's earnings were actually very bad, and so far only credit has figured it out. Equities, being traded now exclusively by Fed-frontrunning retards and virus-infested robots, are a little slow." Prophetically, the equity slowness has finally caught up with reality, and BofA and Wells stocks are tumbling. Alas, fins have much more to drop, especially if and when the RMBS and CMBS markets are gutted (incidentally that CMBX III-IV AJ is looking like a screaming short right here, right now). Below is that latest CDS fin rerack - it is a bloodbath.

No one needs to look at stocks to know how JPM, and the other TBTFs are doing. After all they are now firmly in the clutches of the HFT/Citadel/FRBNY pump machine. Yet a glance elsewhere confirms that all correlations between stocks and credit are terminally broken. To wit, note the following CDS spreads as of moments ago:

• JPM 85/88 (+4)
• MER 184/189 (+6)
• MS 170/175 (+5)
• WFC 105/110 (+6)

Be careful trading financial stocks: JPM's earnings were actually very bad, and so far only credit has figured it out. Equities, being traded now exclusively by Fed-frontrunning retards and virus-infested robots, are a little slow.

One look at the huge crowd at today's fantastic SocGen Tail Risk Hedging conference should confirm all fears that the bulk of speculative investors couldn't care less about riding the levered beta market, and instead everyone is focused precisely on the conference topic: how to isolate and hedge for tail risk (in addition to idiosyncratic, market, correlation and macro). While we will share quite a few of the thoughts by such prominent thinkers as Dylan Grice and Stephen Antczak, we wanted to highlight one trade which caught our attention: namely the mispricing of tail risk as represented by equity and credit derivatives in BP at the time when the company's bankruptcy seemed like a sure thing. Due to a major skew resulting from a huge imbalance in implied vol, a perfectly hedged trade which saw the selling of equity vol through near terms puts, coupled with the purchase of default protection via 6 month CDS, would have yielded a 158% annualized return at trade unwind 3 months later. In other words, which it is difficult to generalize, it appears that in times of dramatic risk, equity derivatives tend to overprice fat tail risk, while default protection is underpriced. Such capital structure arbitrage trades will become increasingly more profitable as the Fed-created drift between equity and credit accelerates, and as vol pricing allows phenomenal arbitrage opportunities.

We are continually amazed at movements in the foreign exchange market that come as a direct consequence of moves in peripheral 5-Year Credit Default Swaps (CDS). The chart below details the relative correlation of a GDP weighted basket of the relevant countries within the Euro. The relationship makes sense. When spreads blow out they do so because investor anxiety over Europe's credit position increases, anxiety over credit worthiness in Europe sees investors selling EUR/USD. However lately moves in the smaller peripheral components have been resulting in out-sized moves in the EUR. Something strange is a-foot.

Irish CDS, which recently was trading wide of 300, tightened materially after the country, most likely with a very direct ECB intervention, managed to place two €0.75 billion auctions, the first a 4% due 1/15/2014, and the second: 5% due 10/18/2020. The Bid To Cover on the first was 5.4, compared to a BTC of 3.1 at the last auction held in May, explained simply by the surge in the rate from 3.11% to 3.627%. The 2020, however, saw the BTC drop from 3.0 to 2.4 as the yield dropped from 5.537% to 5.386%. In other words, the ECB overbid for the near maturity, and likely just put in for a token amount. And for some odd reason, CDS traders see this latest central bank intervention to extend and pretend as a favorable development, and have decided to run away from Irish risk for the time being. The question of how long the ECB can continue this charade is relevant: after all the Fed has just one country to deal with. And continuing with Ireland, the country's central bank stated that the net cost of Anglo-Irish to the government may be €22-25 billion, even as it cleared up hypocritically that capital raising via taxing banks' excessive reliance on short-term borrowings would be preferable. Of course, the central bank should keep its mouth shut, and be happy that the ECB will continue to support any part of the curve, as in its absence the country would be long insolvent.

Now that sovereign CDS (and ratings) are back in vogue with everyone finally expecting the world to relapse into a double dip, Zero Hedge has compiled Moody's sovereign ratings and spread these alongside the CDS levels in any given bucket to propose several trade ideas taking advantage of Moody's market lagging inefficiency.

As part of its most recent FCIC grilling, David Viniar left the political theater a month ago with a homework assignment to disclose all of the firm's derivative profits, as well as provide granular detail on its derivative trades. Today, courtesy of a memo from Goldman intercepted by the WSJ, we now know that derivative trades accounted for between 25% and 35% of 2009 revenue. "Based on the percentages provided by Goldman, such businesses generated $11.3 billion to $15.9 billion of the company's $45.17 billion in net revenue for 2009." As a reminder, the Office of the Currency Comptroller noted (table 2) Goldman had $49 trillion in total derivatives as of Q1. However, the bulk of the profit comes from trading credit derivatives where Goldman, post the assimilation of Bear and Lehman into the collective, is now virtually an undisputed trading powerhouse, and due to the OTC nature of the product allowing firms to set bids and asks as is, as long as liquidity in cash products continues to decline, Goldman will continue to dominate not only the most profitable vertical of derivative trading, but CDS will continue to generate roughly a third of the firm's profits, for both flow and prop. Post the recent shifts in prop trading across Wall Street, it will be interesting to see what the impact on the top line will be now that allegedly CDS trading at Goldman will be exclusively on a flow basis. The irony is that the Volcker Rule seems to focus almost exclusively on equity trading, while the bulk of the firm's questionable flow-prop "Chinese wall" transgressions may occur precisely in derivative trading, and should be the one area under much more scrutiny by regulators and legislators.

The last few weeks there have been a whole bunch of puttable CDs being issued by European banks, and overall apparently that has given money markets some confidence and money is being put to work. That also explains why people have been buying EDU0 99.50 and 99.625 calls or the future outright, a thawing of the funding market would clearly lead to lower Libor, and the Fed which had started pulling liquidity away has basically stopped with global liquidity indicators showing signs that cash has been added to the system. Those puttable securities allow money market funds to treat it as a trade of maturity the put notice, rather than the full duration of the CD is the option is not exercised: you basically get a 1Y rate for a 7 day deal yeeeehhaaaaw! So Money Funds love it, and even though the banks don't get credit for full duration liquidity but instead liquidity that has the put notice as duration, it allows them to fund themselves. No wonder European banks love it too. It then makes complete sense to see EURUSD doing a bit better even when stocks sell-off, and we get compressing swap spreads and lower vol as well (helped by both selling of the optionality by money market funds who only really care about going around their new SEC regulation not buying options, and a slew of agency issuance being digested).

Nic Lenoir

Another week, another major derisking of European names. While the drop of China out of the Top 10 can only be attributed to the summer doldrums, the top countries are mimicking the World Cup Final, and are all European, amounting to over $1 billion in net notional derisked in the past week. These are Germany, Italy, Spain, Austria and the Netherlands, with Greece and Poland at 6 and 7, and Brazil, South Africa and Colombia rounding out the top 10. On the other end, by a smaller margin, the rerisking of France and Portugal amounted to just over $500 million in the past week. The most active name was Brazil with 1,109 contracts unwound or almost $10 billion in notional, even as the net change was one of derisking. It appears Europe will have no peace from CDS "speculators" testing out the ground in each and every country, until it the rolling wave of defaults finally sets in as Niall Ferguson stated earlier.

A month ago, Sarkozy was pissed that Merkel had dared to take the initiative over him and to ban naked CDS trading. Being a stubborn reactionary, this action only prolonged his inevitable decision to do the same (because politicians, being the wise Ph.D's they are, realize fully all the nuances of screwing around with the financial ecosystem). However, looking at this week's DTCC data, we have a feeling he may accelerate his decision to join the CDS-ban team. With a total of 456 million in net notional derisking, France was the top entity in which protection was sought in the past week. In a very quiet week, where the 5th most active name did not even make it past the $100 mm threshold, France was more than double the number two sovereign - Mexico (we are unclear if this is some sort of contrarian move to the Yuan reval, which Goldman was pitching as MXN positive, which means traders likely hedged by loading up on Mexican CDS). But what is probably most notable, is the sudden and dramatic appearance of China in the top 3rd position. Welcome China! And after tonight's surprise PMI miss and the resulting market drubbing, we are confident within a week or two, China will promptly become a mainstay of the top 3, and will quickly rise to the top position, where it rightfully belongs. We are also confident those perennial Eastern European underdogs, Romania and Bulgaria will shyly make an entrance in the top 10 next week.

Several weeks ago we urged readers to consider CDS of Greek neighbors Bulgaria and Romania. Even as spreads of the two countries have widened materially over the last 10 days, especially following last week's news in which a Romanian court found pension cuts critical for IMF loan procurement unconstitutional, there appears to be much more pain to come. In a report from Moody's, the rating agency confirms our worries, in a piece titled "Continued deterioration of loan quality pressures Bulgarian banks." In the report, analyst Elena Panayiotou notes: "Last Wednesday, the Bulgarian National Bank released figures for problem loans at Bulgarian banks, showing a tripling in the percentage of bad and restructured loans to 11.4% of total loans at the end of May 2010, compared with 3.66% a year earlier and 10.7% in April. This is credit negative for Bulgarian banks, as the recent increase in problem loans will further impact the banks’ net profitability, given the requirements to set aside higher provisions for such loans." Since the Bulgarian currency is pegged to the Euro courtesy of the IMF's currency board, the country is effectively as powerless to inflate its way out of troubled bank balance sheets as its eurozone members. With Bulgarian CDS at 360, and with the country about to experience the double whammy of the collapsing Greek economy, and deteriorating asset value, we firmly believe a fair target this spread is at least half of where Greek 5 Year protection trades.

In his latest analysis, Goldman credit strategist Charles Himmelberg resumes the firm's party line of claiming the market is overestimating the risk impact of "fat tail" events, because presumably, as Goldman's Javier Pérez de Azpillaga showed previously, even though Spain is insolvent, is facing a massive budget deficit, has a huge debt-rolling problem, and has a banking system that is locked out of capital markets, all is good (full report here) and all those who are betting on Europe's demise are about to lose money (how this Eurozone optimism jives with Goldman's recent downgrade of the EURUSD to 1.15 is beyond non-lobotomized comprehension, so we'll just leave it be as yet another fully expected Goldman inconsistency). Yet, as ever so often, inbetween the conflicts of interest, Goldman does tend to provide that occasional piece of useful, actionable information. In this case, Himmelberg has done a very relevant analysis comparing Jump to Default costs for CDS and for out-of-the-money equity puts on distressed public names, and concludes that purchasing CDS provides a far better, lower-costing entry point to hedge against default. As he notes: "Our results show that pricing in the two markets follows the same trend, but that credit protection may be cheaper in many cases." Specifically, anyone wishing to arb the mispricing of credit and equity downside protection would be wise to put on a pair trade basket where one buys CDS/sells OTM Puts in SFI, LIZ, BC, MIR, NYT, and DDS and the inverse (sells CDS/buys OTM Puts) in F, AMR, MGM, TSO, SFD and LEN on a DV01 neutral basis, and wait for risk normalization between equity and credit to lead to a recoupling in the spreads.

Several days after the Romanian parliament passed a law to cut pensions by 15% in order to qualify for a critical $20 billion IMF loan, the Romanian Supreme Court found this law was not only unconstitutional, but unappealable (along the lines of what our own SCOTUS will do once the Fed's transparency appeal gets to the very top, resulting in confirmation once and for all that American laws are only made for the benefit of the Federal Reserve). The decision was reached hours after dozens of Romanian citizens stormed the presidential palace "to get an audience with President Traian Basescu." As a result of the Constitutional Court's decision, the IMF loan "may now be delayed, and this will be a big blow to the government of Prime Minister Emil Boc, the BBC's Nick Thorpe reports." Also as a result, Romanian (and by association, neighboring Bulgaria) CDS blew up today and closed +30 to 410 for Dracula's host country, and +20 to 360 bps for the country that served as the reverse engineering center of the former Communist Bloc.

So much for that Greek bailout plan. Greek CDS are now back at fresh all time highs as the market seems set on not only testing the EU's rescue resolve, but determined to get a fresh new bailout plan entirely. At last check CDS was just shy of 1,000 bps. The immediate catalyst is a Fitch report that says Greece risk has gone up and that the country will need further consolidation in 2011 and 2012. The broader catalyst is that the entire Greek credit market is completely dead (noi cash liquidity) and momentum trading has now arrived in CDS, which is the only place left to express a bearish stance on Greece. Should the spread onslaught continue, we expect all of Europe to follow Germany's example and immediately ban naked CDS shorts across the continent. Luckily, both China and India are now set to open CDS trading of their own.