Credit Problems Spreading to the Big Boys

From the WSJ:

In recent days, investors in credit-default swaps, which act as insurance policies against defaults, have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes are at records and have doubled since the start of the year, meaning investors who sold this insurance suffered losses. The worry is that the indexes' moves could prove to be self-fulfilling prophecies, causing heavy losses for investors and making it even harder for people and companies to borrow money. Adding to the anxiety: Analysts can only guess at the volume of investments tied to the indexes, who is holding them and what it would take to trigger a full-scale sell-off.

.....

The trouble is brewing in the market for these esoteric investments. Markit iTraxx Europe tracks the cost of insuring a basket of 125 investment-grade debt issues by European companies, including banks such as Barclays PLC, beverage company Diageo PLC, and retailer Tesco PLC. The Markit CDX North America Investment-Grade Index references the cost of insuring against default by 125 U.S. and Canadian investment-grade companies, including telecommunications company AT&T Inc., retailer Wal-Mart Stores Inc. and fast-food operator McDonald's Corp.

As of yesterday, the annual cost of five years of insurance against default on $10 million in bonds on the CDX index had risen to $152,000 from $80,970 at the start of the year. The cost of €10 million ($14.7 million) of insurance on the iTraxx had rose to €123,750 from €51,320 at the beginning of the year.

Let's take a step back an look at this situation.

-- First, this is the insurance contract on bonds, not the bonds themselves. Let's remember that.

-- Notice the big cost increase since the beginning of the year. The question is, why? My guess is there are a few reasons. First, there has been a huge amount of bad economic news in the US. Secondly, the election is causing uncertainty, which is something traders hate. Third, there has been no good news from the financial sector for some time. Fourth, there is simply put a ton of anxiety about the next 6-12 months.

-- I have to wonder if the insurance was too cheap and now we are seeing a return to normal pricing. According to the story, the cost of insurance on $10 million of high-grade bonds was $80,970/year. Even though we're dealing with high-grade credits, that still looks pretty cheap to me. While I wouldn't expect the number to be sky-high, I also don't expect it to be pennies-on-the-dollar. Plus, this last expansion has been characterized by a complete misunderstanding about the cost of risk.