Is the CDS market underpricing risk again?
David Reilly at Bloomberg notes that the pricing of credit default swaps on both the US government debt and Campbell’s is the same, while buying a credit default swaps on government backed JP Morgan costs about three times as much. He think this is evidence that risk is being under-priced for industrial companies.
It’s true that the U.S. government has big problems, especially spiraling deficits, while soup is a pretty recession- resistant business. And no bank has been immune the past two years to the credit crunch and housing crisis.
Yet the U.S. government can do a lot more to stave off a meltdown than any private company. And the government has made clear that it won’t allow too-big-to-fail institutions like JPMorgan to go bust.
Holders of Campbell debt, meanwhile, might theoretically wake up to find the company was subject to a massive fraud or that executives had made bad bets that left it insolvent. Don’t hold your breath waiting for a bailout there.
Reilly thinks credit default swaps on many “boring” companies such as Campbell should be more expensive. It’s the kind of argument that someone like Nassim Taleb might make, built on the idea that we’re a lot more vulnerable to black-swan events than is commonly thought. The firms selling the swaps are making the same mistake AIG made.
“If unforeseen events take place at seemingly safe companies, Wall Street firms selling cheap protection may again find themselves singing the blues,” Reilly writes.
That’s undoubtedly true. But the premise of Reilly’s argument is so deeply flawed we’re sceptical about his broader assertion about mispricing. It doesn’t strike us as odd at all that buying insurance against the failure of JP Morgan should be more expensive than buying insurance against the failure of Campbell’s Soup.
Let’s run through some risks that Reilly seems to be overlooking when it comes to JP Morgan’s debt.
We know that the government isn’t going to let JP Morgan go bankrupt. But we definitely do not know what form future bailouts will take. Maybe creditors will be protected in a future bailout. Maybe they won’t. Keep in mind that in the recent bailouts of the auto sector forced bondholders to take deep haircuts.
We also know that the failure of JP Morgan would almost certainly mean that the financial system was in great distress. In that case, anyone who sold insurance on JP Morgan would likewise probably be distressed, making paying off the insurance more costly. It seems what’s happening here is that sellers of swaps are smartly taking into account this risk.
That kind of risk doesn’t apply to isolated failures due to corruption or embezzling. If Campbell’s went down, the credit markets wouldn’t suddenly freeze up. Those who sold the credit default swaps wouldn’t necessarily have trouble getting the liquidity they need to fund the obligations.
Overlooking these kinds of risks is a problem for Reilly’s argument. It’s hard enough to establish you know how to price risk better than the market. And it’s pretty much impossible when you over look important risks.
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