CDS

Minutes ago Jim Cramer, reverting to his traditional inverse bank psychic, whose track record needs just one word of reminder, and that is Bear Stearns, told everyone that Morgan Stanley is fine. It may well be. However, we doubt it, as does the market, which just sent out the firm's CDS up another 32bps to 528bps, the widest since 10/13/08 having only traded wider than this level from 9/16/08 to 10/13/08. Critically for those looking at CDS not being as bad as during the peak of the crisis and gaining comfort from that - CDS did not trade gently to those extremes - it gapped unmercifully wider with incredible day to day volatility. Furthermore, for those talking about how illiquid CDS are and easily manipulated, we remind them that it is bonds that cracked first (a much more broadly owned and traded set of instruments) and only very recently has CDS started to catch up to the wide/risky levels at which bonds trade.

Two months ago we said core European default risk is about to surge on risk transfer fears. This morning German CDS just hit a record. Yesterday, and on Friday, we said Belgium CDS is about to be monkeyhammered. Sure enough, Belgium is the worst performed of all European sovereigns, +18 on the day and soaring and threatens to go offerless as we type on imminent Dexia nationalization fears. And there's your alpha for the day.

The move in Morgan Stanley CDS has been grabbing some attention.  It has moved wider than any of the other banks.  Its exposure to French banks in particular has been part of the reason.  Potential hedging of counterparty exposure has also been listed as a reason. (Once again I can’t help but wonder why derivatives in general, and CDS in particular, didn’t get forced into clearing or exchanges after Lehman). I don’t know whether Morgan Stanley is rich or cheap at these levels, but I think there is more digging that needs to be done and it should focus on Asian exposures because that seems to correlate best to the recent moves.

Back on May 25, somewhere close to the irrelevant equity market's highs, when once again a little ahead of the market curve we suggested that Dexia would be the bank most impacted by the next round of Greek-induced risk flaring, we were banging the table on a long Dexia CDS SUB position. 5 Year subs were trading at 568 bps then. They are now 31/39 points upfront and every day for Dexia could be its last. Which is precisely why we are closing the trade: should Dexia go under it will drag all of Europe with it. We expect a partial or complete nationalization to be announced imminently, which in addition to all other side effects, would lead in a Bear Stearnsing of all accrued profit. With a 20% recovery rate on the CDS, the P&L on the trade is $3.6MM on $10MM notional. Not bad for a 4 month holding period.

We have been discussing US (and European) financial risk for some time (especially recently with regard MS exposure to French banks). Since we published that article, we have seen incredible shifts in MS CDS and bonds even as stocks appear to shrug of some of the reality of the situation. An excellent article on Bloomberg last evening pointed out that not only was MS CDS at rather extreme levels, it was quietly as risky (if not more so) than many of the European banks that are making the headlines. Not only is MS CDS its highest since its spike highs in Q4 2008, the curve is inverted with 1Y risk trading 500/550 against 5Y risk at 455/470 which strongly suggests jump risk (or counterparty risk) is being aggressively hedged. With over $4.5bn of debt maturing in Q4 (which we have been pointing out for months - TLGP issues) and the increasingly binary nature of any outcomes, it seems the only real buyer of any MS debt are basis traders as the difference between bond spreads and CDS has halved in the last few weeks.

Update: CDS now over 200 bps, or over 7 bps since this artice was posted.

This is an emergency announcement for bubble watchers: China CDS has soared to 194.5 bps, +14.5 in the past few hours (a trend first noted here about a week earlier), the biggest relative mover in the sovereign realm, which has just hit the widest it has been since March 2009. Ironically the incremental newsflow was mildly positive after the Final September HSBC PMI came at 49.9, still contractionary, but modestly better than the Preliminary 49.4, and unchanged from the August print. That however brought little solace to China bulls, who have seen their local stock holdings drop significantly in the last few days now that the China "Hard Landing" scenario is becoming widely accepted. Not helping is a just released UBS report which now expects Q1 2012 GDP to drop to below stall speed at 7.7%. Whether or not the country can land softly, or hardly, or at all, with that kind of growth drop, is certainly unknown. Look for more widening in CDS spreads as the China crash thesis permeates the vigilante community which has now picked its next target.

While this morning's bout of ridiculous volatility, especially in precious metals, may be briefly over (but certainly not for long) after gold has surged by nearly $100 from overnight lows, the economic weakness persists despite what the futures are saying. As usual European liquidity is at the forefront, with 3M USD Libor rising per usual and every single day for the third straight month in a row, this time from 0.360% to 0.363%, leading to new all time wides in German, French and Belgian CDS to 111 (+3), 201 (+4) and 301 (+6) respectively, which no matter how hard the /ES frontrunning and momentum machines can try, there is little that can be done to dissuade the market that French banks will soon be in need of a full blown bailout.

Unless something changes in the next 24 hours, I expect we will hear more and more talk about default, not only of Greece but of other countries and of banks. Just in case that happens, here is some information that may help you make good decisions. There will be lots of chatter about the “likelihood of default” the CDS market is implying, but although it can be a useful statistic, it can also be very misleading. Before jumping into trades based on erroneous assumptions, it is worth spending a few minutes reading this. If all it does is confuse you, maybe that is a good thing in itself, because you won’t take a headline about default probability as fact.

As overnight hopes of global bailouts fade, the reality that the markets are on their own has started to sink in across every asset class but perhaps credit - the life-blood of everything we do economically - is hurting the most. Senior financials are 14bps wider at 317.5bps (record wides), Main is 11bps wider at 209bps, and XOver 36bps wider at 880bps. Yesterday saw sovereign selling focused in the majors but today it has spilled over into everyone else as commodity producers have maintained their relationship with oil and have snapped wider. While SovX is 'only' 11bps wider at 368bps, CEEMEA is 41bps wider at 390bps overtaking SovX for the first time since June back to its more 'normal' position cheap to Western Europe.

While equity markets in the US have been hurt hard the last 24 hours, credit has been signaling notably more weakness than equities for a while. Today's action follows a similar path to Europe with equities underperforming credit and catching up to credit's view. Last night saw the credit indices close considerably cheap to their fair-value as investors grabbed index overlays as the most liquid hedges - today we some unwind of that as HY bonds are net sold and single-name CDS are decompressing considerably.

If you think this morning has a September 12, 2008 smell and feel to it... You are right. Complete and total CDS bloodbath in sovereigns and fins means a global bailout may not be imminent, but the market sure demands it as contagion has been upgraded to gangrene. Bernanke has now officially blown it with the twist and Mr. Market demands a $1 trillion+ LSAP, or else...

China's HSBC Flash Manufacturing PMI was released earlier this evening and showed continued weakness at 49.4 (below 50 implying a majority of manufacturers saw conditions deteriorating). The continuing moderation of growth is weighing on the Shanghai Composite which is down around 2% but it is the CDS market that is really cracking. 5Y China CDS is now an additional 20bps wider than the 10bps decompression we saw during Wednesday and is back to March 2009 levels at 167bps. It seems global markets are disrupted.

UPDATE: A number of Asia-Pac Sovereigns are cracking wider this morning.

The contagion is getting every closer to the core, with risk in Italy (+6) and Spain (+11) getting ever closer to Austria (+5), Germany (+1) and the UK (+0.5). Also, some rumbling out of ironclad Scandinavia with Finland +7 to 81.75 bps.

The European Union failed to approve a law or plan to bank naked shorts on sovereign CDS.  Their focus on CDS trading started over 18 months ago when the Greek Finance Minister said that all the short sellers would lose their shirts. There have been a multitude of rumors that it would be banned, but there are many better ways to control the CDS market. In all likelihood, the politicians will remain intent on banning CDS.  I think they will be disappointed with the impact and realize that CDS is not the root of all evil and Europe will still have a sovereign debt crisis, without the benefit now of some short covering and additional price discovery.

Judging by the futures one may be forgiven to assume that sovereign default risk in Europe has moderated today. One would also be 100% wrong. It's contract roll day and Italy downgrade day (first of many: Moody's on deck) not to mention algo ES futures ramp up ignore day, and as a result everything is wider across the board, and Italy 5 Year hit 520 earlier, a new all time record.