Bracing For Asteroid Athens

From Sunday’s Kelly Letter:

Credit default swap spreads on the debt of large US and European banks climbed on concern that Greece is ready to default. A CDS is insurance against a loan default because it requires the seller of the CDS to pay the buyer of the CDS in the event that the loan owned by the buyer goes belly-up. It’s called a swap because the holder of the dead loan “swaps” it for cash, usually the face value of the loan, with the seller of the CDS. The CDS seller gets a dead loan; the CDS buyer gets cash to offset the dead loan.

Because man’s mission on Earth is to unnecessarily complicate everything he dreams up, it’s possible to buy a CDS on a loan you don’t even own. When you do so, you’re paying $10 for the right to be paid $20 when the loan insured by the CDS defaults. Insurance was created to protect against losses, not to speculate. However, it has become another poker chip in the global casino that passes for a financial system.

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Most CDS are owned by speculators who don’t hold the underlying loan. They’re not protecting against anything; they’re betting on a default. Naturally, the more likely the default the more expensive the CDS, right? So, one way to understand the likelihood of a default is to watch the spreads on CDS.

What’s a spread? The price of the CDS expressed as the value of a series of payments on it. If they called it a price, too many laypeople would understand what they were talking about, so they call it a spread. Talk to your mother about the rising price of insuring against a Greek default, and she’ll get it. Talk to her about the rising CDS spread, and she won’t. That’s no coincidence. The less people follow this stuff, the easier it is to trick the masses with bad policy rammed through government. But, I digress.

On Friday, CDS on BNP Paribas (BNP.PA) rose 10 percent, Bank of America (BAC) and Goldman Sachs (GS) 7 percent, Citigroup (C) and Morgan Stanley (MS) 6 percent, and our watch list component JPMorgan (JPM) 5 percent. Each of these banks and many others are considered vulnerable in the event of a Greek default, which is considered more likely by the day. Thus, the price of insuring against default by those who will be harmed in the cascade to follow a sovereign default is getting more expensive.

Another sign that the financial market is bracing for impact by Asteroid Athens is risk-asset correlation. That’s the phenomenon we see in times of trouble when individual stock analysis flies out the window and all stocks are just labelled “risky assets” and traded as a block. You may recall this happening three years ago in the Lehman shock. “Stock?” the market asked. “Sell,” the market answered. End of analysis.

JPMorgan reported that correlation among the S&P 500’s 250 largest stocks reached its highest level since the 1987 crash, at 81 percent last week. It reached 88 percent during the October 1987 US crash, when the Dow dropped 22 percent in a single session. Recent spikes in correlation, including the Lehman shock and the March earthquake in Japan, touched 70 percent. The risk is that current extreme correlation could create a mass trading frenzy, where the whole ship begins going down at the same time and everybody sells to jump off which sends the ship down even faster.

To read the entire market forecast, see what action we’re taking, and look over our extended watch list of ideas, get on the list.