The Bad-News Bonds

Even though the headlines have focused on the travails of S&P 500 members such as Ford(F), General Motors(GM), AIG(AIG), Fannie Mae(FNM) and IBM(IBM), the S&P 600 fell the most once credit quality began to deteriorate in March. The small firms have less access to financing than their larger cousins do, and therefore they will be more vulnerable if the credit markets lock, as they are wont to do in a crisis. Life is not fair, is it?

Linking Stocks and Bonds

Financial postmortems usually discover one of three causes. The first is the assumption of continuous and liquid markets; in reality, liquidity is the only asset whose supply disappears when its price is raised. The second is the assumption that past correlations will remain constant during a crisis; in reality, correlations move to 1.00 in a crisis as panicked traders sell risk and buy safety. The third is what option traders refer to as being short gamma: Any insurance writer is short gamma, while the insurance buyer is long gamma. Who writes the checks after the disaster, and who cashes them?

CDS writers are guilty of all three in some sort of you-have-got-to-be-kidding trifecta. They are short put options on corporate bonds and call options on the stock. They are assuming the stock-bond relationships will remain predictable as a crisis unfolds. And they are assuming they can trade their way out of the situation on the really amusing assumption that someone else will care about their plight.

And to top things off, they have the same risk profile that was present in 1998 during the Long Term Capital Management debacle: They are long on risk and short the safety of the Treasury curve. If the Federal Reserve backs away from its measured pace of rate hikes, as speculation last Friday had it, this last problem will be worsened, as Treasury yields will fall more rapidly than corporate bond yields will. In terms of the risks posed to the financial system, these traders are suicide bombers in pinstripes, if I may date myself with the choice of preferred wardrobe.

If past is prologue, and it usually is, who will be on the hook for any accident? You and me: The CDS writers are the usual too-big-to-fail suspects. If General Motors declares bankruptcy, you and I will own their pension liabilities through the Pension Benefit Guaranty Corporation. If J.P. Morgan gets on the losing end of CDS obligations, we will own those. And we already own the unfunded liabilities of Medicare and Social Security.

We own, we own, we own. That's why we are the ownership society, is it not?

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