The Markets sell the Governator Short

I was looking for just the right twist of irony sprinkled over my reality today. Bloomberg.com served it to me shaken, not stirred, with a delightful, tangy twist. Do you remember our discussions of those not so obscure derivatives called Credit Default Swaps? They’re basically the Wall Street version of a side bet. Some sucker agrees to provide a form of “insurance” that makes some entity is a better risk and some one else bets against them thinking nothing will make that entity worthwhile?

In most instances, the bet is against the holder of the entity’s bond. The holder, at some point, invested in the bond because they thought it a good investment. The investor may who holds the bond may want a little extra assurance so they enter into a swap agreement. If the bond defaults, they get a payment. However, in a lot of instances, the swap may be ‘synthetic’. That means some folks don’t actually hold the bonds or intend to buy or sell the bonds. They want to place a bet on which way the risk premium will move and pocket the difference. (That’s the extra cost associated with the bond if the market deems the bond to be risky or junk.) Okay, hopefully, that’s enough to get you situated but if you want to learn a little more here’s some information on Naked CDS from The Atlantic.

Okay, so now I want to move towards the punch line, if you will. There’s still a huge market for these things. Remember, it’s actually much bigger than the equities markets despite recent events. Here’s the fun headline from Bloomberg: Russia Beats California as Default Swaps Favor BRICs . Gosh, don’t you just hate it when you really have to explain a joke? So, BRIC is short for Brazil, Russia, India and China. So, that mean’s that the bonds of those countries are considered less likely to default than those of California. Grok on that a minute with some special consideration to Russia who defaulted not all that long ago.

Investor demand for emerging-market bonds is driving the cost of insuring against debt defaults below industrialized governments for the first time.

Credit-default swap prices from Turkey to Indonesia are falling as bonds rise amid signs that their economies are recovering faster than developed nations. As the U.S. and U.K. borrow record amounts to fund bank bailouts and stimulus, Brazil, Russia, India and China have $3 trillion in reserves, up 19 percent from January 2008 and now 43 percent of the worldwide total, data compiled by Bloomberg show.

The annual cost of protecting holdings in Turkey’s bonds fell by half to $200,000 per $10 million for five years, or 200 basis points, sinking below New York City swaps for two weeks starting July 22, Bloomberg data show. Indonesia debt insurance dropped below Michigan the next day. Brazil swaps just had their biggest four-month slide ever. For China, protection is near the cheapest in a year. Eleven years after Russia defaulted, investors want less to insure its debt than California’s.

I highlighted the fun part for you. If you continue to read the underlying fundamentals behind these bets you’ll see that Russia’s huge Reserve Funds (mostly rubles they banked when oil prices brought in lots of revenues) are being released into their economy. Same with China who has a huge reserve of dollars from our trade deficit with them. China’s just set a record for bank loans and they put a government stimulus package in play. Even Turkey (yes, TURKEY) is doing similar things. This has led the IMF to give each of these countries much more bearish economic outlooks than the U.S. and definitely California (which still ranks, on its own, as one of the world’s largest economies).

“If California is issuing their own dummy currency in the form of IOUs, that’s not a good sign,” said Augustus’ McNamara.

Russia has an “extremely low” debt-to-GDP ratio of about 10 percent which is attractive to “any type of bond investor,” said Luis Costa, an emerging-market debt analyst at Commerzbank in London. “For as long as U.S. municipal and state governments are in trouble, I think this trend will continue.”

By comparison, the U.S.’s $11.2 trillion of debt is about 79 percent of its $14.1 trillion in GDP, Bloomberg data show.

Issuance of Treasuries by the U.S., which has spent more than $300 billion to prop up its banks, may total $446 billion this quarter, up 30 percent from the prior three months, according to a Securities Industry and Financial Markets Association survey published July 30.

The extra yield investors demand to own developing country bonds over similar-maturity U.S. Treasuries dropped to near a one-year low of 3.41 percentage points this week, from 6.95 in March, JPMorgan Chase & Co. indexes show.

Equally disturbing is the news that the swaps for New York are on the move too, and not in a good direction. So, what does this mean? Well, folks, it means in the side bet of global economics and finance, every one is selling us short or to put it even less tactfully, they are betting against us. Wow, it’s only 3 p.m. CST time and I already need the cocktail hour to start. Maybe I need to swear off Windsor rules and switch to something more apropos to Russia. Na zdrovye!

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