Moue Magazine

This is a chart of the CDS spread from yesterday, courtesy of Baseline Scenario, and it paints a less rosy picture of Citgroup than the company’s memo (and Wall Street’s reaction). Credit default swaps (CDS) are essentially insurance policies issued against bonds (or bond-like investments) that allow the investor to put most of the risk in the hands of others for a fee. They have serious drawbacks (see: AIG, near collapse of) but have historically served as indicators as which direction things are heading.There are those who think that the market is so broken at this point that CDS spreads don’t offer reliable readings but there are others who think they’re still worth a glance. 

The basics of how this spread deal works (again, from Baseline Scenario): 

The price of a credit default swap is referred to as its “spread,” and is denominated in basis points (bp), or one-hundredths of a percentage point. For example, right now a Citigroup CDS has a spread of 255.5 bp, or 2.555%. That means that, to insure $100 of Citigroup debt, you have to pay $2.555 per year.

CDS exist for various durations and on many different kinds of debt. If someone doesn’t specify the duration or the type of debt, he is usually referring to a 5-year CDS on senior debt. That means that the contract will be open for 5 years, during which one party (the insured) pays premiums and the other (the insurer) promises to pay off if Citigroup defaults. If there is no default within 5 years, the insurer gets to keep the premiums.

Look at it from the standpoint of the insurer. If Citi doesn’t default, I get $2.555 x 5 = $12.775. If Citi defaults immediately, I have to pay $100. That implies that I think there is about a 12.8% chance that Citi will default (ignoring the time value of money). Actually, my expectation of a default is actually somewhat higher, for a couple of reasons. First, if Citi defaults 4-1/2 years from now, I have to pay $100, but I’ve collected the $12.775 in the meantime (assume premiums are paid at the beginning of each year for simplicity), so my loss is only $87.225. Second, in any case I don’t have to pay the full $100; I only have to pay $100 minus the value of the security, which is unlikely to be zero even in the case of a bankruptcy. For example, Lehman bonds were only worth 9 cents on the dollar (so insurers had to pay out 91 cents), but Washington Mutual bonds were worth 57 cents. So my net loss will be lower, which means that my expectation of a default is higher. (The expectation is the money I expect to gain if there is no default, divided by the net amount I expect to lose if there is a default.)

That excerpt is from an article written in November. As you can see from the chart, Citi currently much higher than the 255.5 bps used in the example. It posted yesterday at 585 bps, which was actually a 55 bp tightening based on the optimistic mood. Using the same, simplistic equation from the excerpt, if you had $100 of Citi debt, you’d have an annual fee of $5.85. From the insurer’s standpoint (again, on a 5-year CDS) that would be $5.85 x 5= $29.25 that they would earn if Citi doesn’t default. The insurer belief that Citi is going to default would be over 30% after adjustments. 

Compare that to JP Morgan (the bottom, fuchsia colored line), who are considered the best of the worst banks, and you’ll see a wide gap. I’m not going to look up JP’s exact bps but let’s set it at 230 (or 2.30%) for simplicity. That would be $2.30 on a $100 investment. For the investor, 5 x $2.30= $11.50 with a likely default risk right around 15%. 

As noted above, this is more a hint than a tea leaf reading. But it appears that Citi still has a very long way to come regarding investor confidence.