In a blog entry almost six months ago, I suggested that prices for credit default swaps (CDS) would tell us when the financial crisis was winding down. Unfortunately, the data this week tell us that the end is not in sight. This is probably obvious to you given the news headlines of the last few days, but looking at credit default swaps can help us understand how bad things are.
Default swaps, you may recall, are financial instruments that let you buy insurance against the event that a bond defaults. If a default does occur, the default swap lets you surrender the bond to the swap counterparty (who is the insurance seller) in exchange for its face value.
The price of a default swap, typically expressed in basis points per year, is an annual insurance premium. The easy way to interpret a default swap price is that it is the annual cost of insuring a $10,000 bond against default. So a quote of “700” means that you would pay $700 per year to insure against default on a $10,000 bond. All of the CDS prices I will show are for 5-year contracts on senior bonds. The insurance buyer will pay the quoted CDS price annually for 5 years. The CDS price is on the vertical axis.
The first figure (below) shows CDS quotes for a handful of large, not-yet-bankrupt (hopefully, not-soon-to-be bankrupt) financial institutions. Most notable are the quotes for Morgan Stanley and Goldman Sachs. These firms were being touted as solid, having either sustained no losses (Goldman) or relatively moderate losses (Morgan) in the last year. Nonetheless, the market appears to have lost faith in them, as evidenced by large CDS quotes. Insuring Wednesday against a Morgan Stanley default for 5 years would have cost $1,000/year for a $10,000 bond. For Goldman the cost would be over $600/year. This reflects a critical and astonishing lack of confidence in key financial firms, and the practical effect is that they have to pay high interest rates to borrow money. This is why Morgan Stanley is trying to merge with a bank like Wachovia. A financial firm thought to be a risky counterparty cannot remain in business. You can see that the CDS quotes dropped a little on Sept 17 following the AIG rescue.
What about the non-financial sector? A serious fear is that the turmoil on Wall Street will cripple large non-financial firms. While the prices of almost all stocks have ricocheted over the last few days, CDS quotes have not been extreme for large non-financial firms. The next figure just below shows CDS quotes for a set of firms in the Dow Industrial of 30 firms. With the exception of Boeing, CDS prices are below 100 and Exxon-Mobil is below 40. By comparison, in June 2007, the CDS price for Exxon-Mobil was 3.
Also on the graph is the CDS price for US Treasury bonds. It has tracked the crisis, reaching an historic high this week with the AIG bailout.
There are, of course, industrial firms in serious trouble. The final graph depicts automakers Ford and GM, and for comparison, AIG. Here, the CDS quotes show that you would have to pay almost $2500 to insure against default on $10,000 of GM bonds, and $1800 for Ford bonds. By comparison, the AIG CDS price reached $3500 before dropping to $1400 on September 17.
What do we conclude? We’re not nearly out of the woods. The financial sector is still in big trouble. The good news is that the market apparently considers much of corporate America to still be a relatively good credit risk, albeit riskier than 15 months ago. Should CDS quotes for large non-financial firms skyrocket, this will signify that we are in much worse shape.