As we all have seen in recent months, the world has become a cascading wave of financial market volatility with almost every stock market worldwide suffering sizable downward corrections in recent weeks. As these markets lose value, it tells us that investors are pulling their money out of the markets. Traditional trends tell us that most investors, when moving out of stocks move into bonds, therefore; on days when the stock market drops, bonds benefit as money from stocks is placed in bonds.

This is, of course, the traditional model, but there is a historical precedent when both stocks and bonds declined at the same time. That time was the Great Depression. As you watch and wonder what market downturns mean, also keep your eye on many things which can tell you what is coming next. Factors such as drops in stocks and bonds at the same time, which signal wealth being cashed in and removed from the markets, increases in CDS (not CD’s that banks offer, but Credit Default Swaps) which tell us the likelihood of bankruptcy of the issuer of the CDS.

Credit Default Swaps are a very misunderstood element of the economy. Watching their default rate tells us the health of the organization and the loans/bonds it makes or acquires. When a company, government or entity sells a CDS, it is basically acquiring the debt via investment instrument where the buyer pays the seller installments and, in the event of a default in the loan(s) and/or bond(s) in the CDS, the buyer gets a payoff. If it sounds confusing, it is. CDS are a relatively new invention first put forward in 1997 by JP Morgan Chase as an investment vehicle designed to limit losses on defaulted loans and lessen the necessary reserve holding by banks in order to service new loans via risk reduction and artificial inflation of the balance sheets.

All of this being said, lets look more at how CDS can tell us about the health of the agencies selling them. The higher someone’s CDS rate is, the more likely that they are to default, file bankruptcy or just outright fail. Money Week published a good article in March 2008 with a list of CDS rates of banks and an explanation of how to spot vulnerable banks which may fail. The list of banks on this list has been updated, surprisingly to most, a majority of the banks listed are not US-based. The spreads are measured in basis points, therefore 100 basis points is equal to 1%. Warren Buffett even referred to CDS as “financial weapons of mass destruction.”

So where did it all go wrong? Now, remember, when a bank makes a loan, it must have a reserve on hand to cover deposits, possibilities of default, etc. Such reserves are defined in Modern Money Mechanics, a discontinued publication on the Fractional Reserve Monetary System produced by the US Federal Reserve. The book, “The Web of Debt” better explains such principles in more understandable English. Banks, knowing that they must keep reserves began to try and find ways to make loans and investment vehicles which did not require the reserves to be kept on hand, in other words, ways to make money free of obligation. The idea was to create a product that could be sold as an investment which protected the bank from suffering losses in the event of a loan default. Banks then, invested in their own and each others CDS in order to, in theory, limit losses due to defaulting loans or crashing bonds. The error in thinking was that they no longer needed reserves to cover defaults and that the newly invented CDS instruments would function like bad loan insurance. Money Week does an excellent job of conscisely explaining the issues with CDS in an October, 10, 2008 article.

Now that you should have an idea of what CDS are, and how they have destabilized the global financial system, you can begin to see why default rates become so pivotal in gauging risk of failures within organizations issuing CDS. This is, unfortunately, not the end … it is only the beginning. With the knowledge you now have, let us examine together some frightening CDS rates held by things we think are too large to fail.

• Passing of the $700 billion bailout bill caused US CDS rates for Treasury Bonds to soar by 40% (report from Bloomberg on October 29, 2008)
• MarketWatch reported that spreads on CDX North America Investment Grade index, which tracks debt of 125 companies in the US and Canada climbed to a record of 275 basis points on Thursday, November 20, 2008 signaling that the worst may yet be to come. Before Thursday’s report, the CDX spread had already doubled during the 2008 year.
• As of October 17, 2008, Iceland’s government had a CDS rate of 948 basis points prior to its financial collapse. Those watching the news would know that this has deeply affected Iceland as citizens are protesting and demanding accountability.
• The United Kingdom’s CDS rates have climbed to 88 basis points on November 24, 2008, a new record, amongst fears that the UK may be headed in the same direction as Iceland.
• Following Barack Obama’s speech and pledge of $800 billion in additional bailout funds, US CDS rates soared to a new record of 56 basis points on November 26, 2008. Furthermore, fears abound that the US’ AAA credit rating will soon be downgraded as deficit spending nears $1 trillion dollars for the current year.
• If you do not believe that the US could go bankrupt, consider the fact that, based upon CDS rates, California (CDS rate of 165) poses a greater risk of bankruptcy than Slovakia (CDS rate of 150) and Michigan (CDS rate of 192) is more in danger of bankruptcy than California.

These are just a few reasons why you should watch CDS rates and be prepared as CDS markets may become the next victim of the slumping economy. As CDS rates increase, business and governmental failures mount, and the guarantees made by CDS sellers cannot actually be kept, we could be entering a new tidal wave of economic loss inundating our already weakened global financial markets. The result of such events could very well be the demise of many nations, banks and companies.

Furthermore, should our government continue haphazardly giving money away, their own CDS rates against US treasury bonds will continue to soar, resulting in loss of the US’ AAA credit rating which will escalate interest rates on US debts and make further borrowing to finance deficit spending almost impossible to acquire. In short, we could be watching the beginning of the end for the US government as fears of bankruptcy spread from the tinfoil hat community into the financial markets and beyond. Economies, such as ours, who have constructed such elaborate pyramid schemes as the CDS market will be most difficult to repair.

“The major difference between a thing that might go wrong and a thing that cannot possibly go wrong is that when a thing that cannot possibly go wrong goes wrong it usually turns out to be impossible to get at or repair.” – Douglas Adams

Tags: CDS, Credit Default Swap, Iceland bankrupt, pyramid scheme