Michael Gracie

Spreads in the gargantuan credit default swaps marketplace are forcing otherwise platinum rated borrowers to pay significantly more for their money. A bit of this is to be expected - up until summer credit spreads were tighter than a snare drum, and some widening was to be expected. But nobody foresaw GE paying 129 basis points over the government yield (they’re probably more credit worthy THAN the government ).

Will the anomaly work itself out in due course…?

“The credit-default swap market is completely distorting reality,” said Henner Boettcher, treasurer of Heidelberg Cement in Heidelberg, Germany, the country’s biggest cement maker. “Given what these spreads imply about defaults, we should be in a deep depression, and we are not.”

Or should there be a “Yet.” at the end of the above statement?

According to Bill Gross:

“Credit-default swaps are perhaps the most egregious offenders” in today’s banking system, Gross wrote on the company’s Web site today. “Our modern banking system craftily dodges the reserve requirements of traditional institutions and promotes a chain letter, pyramid scheme of leverage, based in many cases on no reserve cushion whatsoever.”

Agreed in theory, but not necessarily in quantity. Based on the prospective notional value of credit default swaps at December 2007 of around $50 trillion, Gross’s estimate would put defaults at around 0.5%. Certainly, a lot of these swaps were hedges against other swaps, but the rate still seems darn low.

Here’s a tasty look at the notional value of the credit default swaps outstanding (*) for the last few years:

The notional value is essentially the par value of the underlying credit. We know there was a heck of a lot of credit being granted during the period, and it also seems that a lot of “insurance” was being written against its potential for default.

Around the same time bankers everywhere were looking over their shoulder if someone asked them how their debt portfolio was doing, everyone and their mother was scrambling for sanity in the rate markets (*):

Of course, there’s an awful lot of speculation buried in those numbers, as well as hedging previous hedges. How it all unwinds is anyone’s guess. Meanwhile, investors are “bracing for more bad bank news”. With banks bantering around numbers in the tens of billions, while exposure is floating around in the tens of trillions, I wonder what investors are actually “bracing” with.

Meanwhile, at least a few analysts are starting to speak out (and keep in mind that sub-prime is only a sliver of the total indebtedness floating around).

* Data taken from the International Swaps and Derivatives Association’s twice yearly dealer surveys.

UPDATE: Just a sliver.