Credit-default swaps (CDS) were designed as a way for lenders/investors to buy “insurance” against a borrower’s default. CDS can be structured in many different ways, but, to take a basic example, an investor buying a French government bond might decide to enter into a CDS linked to that bond with a third party. The investor will pay the third party (an insurance company, say) to “guarantee” the payments due to it from the issuer of the bond (the borrower) in the event of default.
There is an active market in CDS, although it’s smaller, more standardized, and much more regulated than before their unhelpful contribution to the financial crisis (the notional value of outstanding CDS in 2007 was over $61 trillion; it’s a small fraction of that today, although still in the trillions). CDS are, as discussed above, a form of insurance against credit risk, but they can also be bought or sold purely speculatively by investors with no direct connection to the original bond. Such investors may think that the risk of a default (or of rising expectations of a default) is not adequately reflected in the price of the CDS and take advantage of that to buy. Other investors may decide that the pessimism has been overdone (and thus that the CDS is too expensive) and sell.
All this is to say that the fact that the price of one-year CDS insuring against a U.S. government default has exceeded peaks seen during the financial crisis could reflect (in part) speculative activity. Moreover, writing for the Financial Times on April 22, George Steer reported analysts’ comments that the one-year CDS market is small and not that liquid. If that’s the case, it could easily lead to exaggerated price movements. At the time Steer was writing, a one-year U.S. CDS was trading at over 100 basis points. For comparison:
CDS for the most creditworthy countries typically trade between 25 and 50 basis points, according to analysts at ING. “The US is clearly considered a much higher default risk than most [other countries],” said Antoine Bouvet, the . . . head of European rates [for ING, a Dutch bank].
He pointed out that equivalent CDS for Italy, the UK and Greece were currently trading at 39, 14 and 46 basis points, respectively. “Genuine” near-term default candidates see spread levels in the thousands. Even so, “markets aren’t relaxed about the risk of US default”, Bouvet said.
Indeed, the price of five-year credit default swaps — the most widely traded form of debt insurance — also reached its highest level in more than a decade this month, at 50 basis points.
Moves like this are no reason for panic (yet), but they are, obviously, not a good sign.
In a way, that prices have surpassed the heights seen in 2008 makes sense. While the financial crisis took markets to a place where they should never want to be, there was — for anyone who thought it through — an awareness that Washington had the firepower to act. What’s different now is that Washington still has, so to speak, that firepower (in this case raising the ceiling) but is deadlocked on whether to use it.
These market tremors can be expected to increase in force as the date (June? July? August?) when a default can no longer be deferred (the X-date) approaches.
Meanwhile (via Reuters):
First Republic Bank’s market value plunged again on Wednesday as investors waited to see if it would be able to find buyers for assets and engineer a turnaround without government support.
In a brutal sell-off, the bank’s market capitalization briefly sank as much as 41% to about $888 million and the first time under $1 billion, a far cry from its peak of more than $40 billion in November 2021. It closed around $1.1 billion.