Update: Banks’ CDS. Still the King

by Enis May 10, 2012 5:41 pm • Commentary

Update May 10th, 2012:  

JPM is lower by more than 6% after hours after an announcement that they will be taking a $2 billion trading loss from positions in their Chief Investment Office.  Putting the myriad of media headlines aside, we just listened to the conference call where CEO Jamie Dimon laid out the reasons for this loss.  It could not be clearer to us what occurred.  As Bloomberg first reported in April, hedge funds said that JPM’s CIO had been selling a very large amount of CDS.  Selling all of that CDS has now left JPM at risk if CDS spreads go wider.

Dimon basically said that JPM does not want to exit these trades because their positions are so big  so they are going to leave the short CDS position on their balance sheet, with the hope of covering it over time.  Unfortunately, that means JPM’s VaR (Value-at-risk) measure has just more than doubled from 67 to 143, as Dimon said on the call.  As traders, we know the scenario where the rest of the professionals know one big firm’s position.  JPM will not be able to buy that CDS from other market participants.  Expect much bigger losses for JPM on this short CDS position over the coming quarters.



Original Post May 8th, 2012: Banks’ CDS. Still the King

The corporate bond market is significantly underappreciated by the mainstream media.  While stocks get all the attention, the U.S. corporate bond market is estimated around $7-9 trillion, by far the largest corporate bond market in the world.  In fact, part of the reason why the European market is so heavily impacted by European banks is the heavy reliance within Europe on bank loans as opposed to corporate debt.  They would have been better off spreading around some of that risk.

And in my experience, credit market participants are plain smarter about their companies.  That’s coming from an equity guy.  The debt analysts and traders routinely knew more than me about a given story, but I couldn’t say the same for most equity people.  Because the credit people cared about return OF principal, not return ON principal.  It made them research each company in more depth.

I mention all this because every trader should pay attention to the CDS market.  The CDS market is smart.  Very smart.  And it often holds clues that stocks only find out about later on.  This is particularly true for the financial sector, where the debt outstanding dwarfs the equity.  Best of all, comparing CDS to options gives us a metric to determine when options are mispriced, since both are forms of protection (CDS for corporate bonds, options for stocks).

Looking at the banks today, options seem too cheap compared to CDS in the weaker credit names.  For example, in MS, looking at a chart of 1 month implied vol (green) vs. 5 year CDS (purple), we can see that the CDS is much higher than it was last spring and early summer, but implied volatility is close to those low levels:

Similar story in C:

And in BAC as well:


However, the higher quality banks, at least as viewed by the credit markets, have both CDS and implied volatility similar to where they were last May.  For example in WFC:


Similarly in USB:

Charts courtesy of Bloomberg

The credit market is distinguishing between the names that have large investment banking divisions with significant international counterparty risk, and those names that are almost purely domestic.  Simply put, the options market is not pricing in enough volatility for the investment banking exposed names.  And it’s why we have been and will continue to recommend buying options on C, MS, and BAC to express both bullish and bearish views.