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Issue #1270: CDS's, so hot right now

Issue #1270: CDS's, so hot right now

Oct 3, 2022
Marty's Ƀent

Issue #1270: CDS's, so hot right now

Twitter has been abuzz with people calling for the imminent collapse of Credit Suisse, the Swiss investment bank that has been around since 1856. Many are pointing to Credit Suisse's credit default swap spreads highlighted in the chart above as a clear indication that the market is bracing for the company to go under. For those who need a refresher, a credit default swap is a means to hedge risk against a credit event. An insurance policy on a debt-instrument failing. These instruments were made famous in 2008 by the likes of Michael Burry and Mark Baum who created and bought credit default swaps that bet on the failure of mortgage backed securities.

To be honest, I have no idea whether Credit Suisse is about to fail. Things certainly don't look good. Especially when you take a look at how the company's stock has been traded throughout 2022.

via Google Finance

60% of shareholder value wiped out over the course of nine months isn't very confidence inducing, which is likely part of the reason Credit Suisse CDS spreads are at 14-year highs. With that being said, again, I have no idea whether or not Credit Suisse is about to go under. I wouldn't be surprised either way. And to whether or not its implosion would mark this cycle's "Lehman moment" that leads to a contagion throughout the banking sector, I'm not so sure this would be the case considering the capital requirements that were put into place in the aftermath of the 2008 crisis with Frank Dodd and Basel III requirements. I think it may be significantly harder to have a bank-driven financial crisis this time around.

With that being said, the signal in CDS markets is pointing toward a much scarier scenario, a nation state-driven financial crisis. Let's take a look at the CDS spreads of sovereign nations as presented here by James Lavish.

As you can see, the 5Y CDS's for nations across the world are trading well above their averages at the moment. If you think about it, this makes sense. The Federal Reserve and other central banks have been raising interest rates over the course of this year in an attempt to curb what seems to be runaway inflation. This has caused yields in many debt markets to soar as well, which is raising interest payments on debt accrued for individuals, companies, and sovereign nations. If you bought a home using a mortgage, issued a corporate bond, or issued a treasury instrument tied to variable interest rates you are feeling the pain right now as your payments on that debt have increased significantly. While it is a bit unsettling for individuals and corporations to be put in this precarious situation, it is absolutely terrifying for many of the world's "strongest" sovereign nations to find themselves in this situation.

It's one thing for a number of individuals to have to default on their mortgages and sell their homes or for corporate debt issuers to default on their obligations and shut their doors, but it's a completely different situation when you have nation states defaulting on their obligations. We're potentially talking about rug pulls of epic proportions if these nations begin to default. The entitlement blow ups that people have been talking about for decades would be upon us and you can bet your ass that there would be a complete collapse in confidence in nation state governments if this winds up happening. The chaos that would ensue is unfathomable.

This is likely why the UN came out of the blue today to literally beg Jerome Powell and other central bank heads to stop raising interest rates.

via The Wall Street Journal

They know how dire the situation is behind the scene. The amount of debt that was racked up by governments across the world during a 12-year reign of unnaturally low interest rates is astronomical. As Albert Einstein famously said, compound interest is the eight wonder of the world. And unfortunately for these governments they are finding out that compound interest is a double edged sword. It swings both ways and it is currently swinging in a direction that could lead many to ruin. Paying off tens of trillions of dollars of debt while the Fed Funds Rate is hovering around the zero-bound may seem manageable for the US government. Rapidly raising rates from 0.25% to 3.25% (13x growth) and eventually to 4.5% (18x growth) is having a material effect on the interest payments of the debt accrued by wreckless governments.

Keep an eye out on these spreads moving forward, freaks. This is where the signal lies. Not in the CDS spreads of the banking sector. Is Jerome Powell running overindebted governments into the ground with his ultra hawkish policy? If so, how long can they persist with a high interest rate environment? How immense will the pressure on the Fed get? Time will tell.

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Final thought...

Another Bent for 40,000 feet above the ground.

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