Central banks apparently watch credit default swaps as the single most important economic indicator. So I’ll keep watching them also as a window into the real state of the economy.
Indicators for credit default swaps shows that several Europen countries, junk bonds, and synthetic CDOs are all getting hammered.
There will be a lot of defaults on these bonds in the coming year, and many people who bought junk bonds (and some companies which issued CDS protection on them) are going to lose money.
Bloomberg has a very good article today on synthetic CDOs and credit default swaps. I’ll quote it at some length, as it gives insight into the relation between CDS and synthetic CDOs:
Defaults and so-called “credit events,” which can include government takeovers, force payment of the credit-default swaps packaged in the debt. This causes losses for investors or erodes capital.
“The same kind of shudders that went through the asset- backed CDO market will probably go through the corporate CDO market,” said Sillis. “We’ll see a pickup in default rates.”
Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. Swaps on Kaupthing Bank hf, Landsbanki Islands hf and Glitnir Banki hf were included in 376 CDOs rated by S&P. The company ranks almost 3,000.
About 1,500 also sold protection on Washington Mutual, the bankrupt holding company of the biggest U.S. bank to fail, according to S&P. More than 1,200 made bets on both Fannie Mae and Freddie Mac, the New York-based rating company said.
The collapse of Lehman, WaMu and the Icelandic banks, as well as the U.S. government’s seizure of the mortgage agencies, will have a “substantial” impact on corporate CDO ratings, S&P said in a report Oct. 16.
The government in Reykjavik seized Kaupthing Bank, the country’s largest lender, earlier this month. Assets and liabilities from Landsbanki Islands and Glitnir Banki were transferred to state-owned entities, triggering default swaps.
Investors may sell the CDOs back to the banks that structured them, which will unwind protection they wrote to hedge swap transactions, Barclays said. The chain of events will push up the price of default protection and company borrowing, according to Barclays.
Banks unwinding hedges helped double the cost since April of default insurance on the lowest-ranking equity portion of the benchmark Markit CDX North America Investment Grade Index, to 75 percent upfront and 5 percent a year. That equates to $7.5 million in advance plus $500,000 annually on $10 million of debt for five years.
Forecasts for ratings downgrades are “going to force a lot of activity” in unwinding CDOs, said Rohan Douglas, former director of global credit derivatives research at Citigroup. ‘