Wall Street Bets on Debt That Doesn't Exist (Wall Street Journal)

By | February 28, 2011

Many still seem skeptical of credit default swaps (CDS), but the reality is (and always has been) that they play an important benchmarking function for the global credit markets.  That’s why when I heard that GM CDS was trading without the existing of any underlying GM bond I wasn’t at all surprised.

Two things to keep in mind.  First, CDS pricing is always done via models that look at the characteristics of the bond (maturity, interest rate, etc.) and the probability of default (which is determined using formulas, but is essentially an educated guess based on the health of the underlying company).  So in this case, despite the lack of any real underlying bond, traders can make some assumptions about the former and have plenty of information on the latter.

Secondly, CDS generally is cash settled.  This practice was taken up years ago to prevent a supply/demand imbalance for the underlying bond when delivery is required.  Therefore, the lack of an underlying GM bond doesn’t really matter.

My quote from the paper:

“Sure, having CDS without debt looks odd, and people may balk because credit derivatives were at the center of the AIG collapse, but that doesn’t change the fact that CDS prices are the de facto benchmark used to measure the state of the credit market,” said Kevin McPartland, senior analyst at research firm TABB Group.

Read the full story at WSJ.com

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