Friday, 6 June 2008

What does a CDS spread on a monoline mean?

That is not quite such a stupid question as it first appears. Consider an industrial corporate. The CDS spread on a company like this reflects were buyers and sellers of credit protection are willing to deal. If the corporate is liquid in the CDS market - roughly 1000 are - then there is typically a two way market and the CDS spread provides valuable information on the market's perception of the company's credit worthiness. Notice that typically counterparties in the CDS market are financials, often well-rated ones - so counterparty default risk is fairly low - and that the default correlation between the typical underlying company and protection providers is also low.

But now consider the monolines. Firstly CDS on them is not a two way market at the moment. There are lots of people who want to buy protection and few new sellers. It has been that way for a while. And secondly the default correlation between the typical monoline and the typical CDS market counterparty is much higher than for most other CDS references: a world in which Ambac is in default isn't good for JPMorgan, for instance. Therefore one could expect a fairly big difference between quoted CDS market spreads on the monolines and where you could actually get a trade done with an uncorrelated high quality counterparty (the German government, say).

I am not saying that the monolines should not trade at hundreds of basis points or that Moody's implied ratings are necessarily wrong. But I do think one should be cautious about what Ambac or MBIA's CDS spread means exactly.

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