Monday, October 20, 2008

Are swaps forecasting a huge equity rally?

I've always been drawn to swap spreads as a leading indicator of other things (e.g., credit spreads, generic financial conditions, fear, health of the economy), so when I put together this chart I told myself to not get too excited, because it suggests that the big selloff in equity markets was just a temporary thing that will soon be almost entirely reversed. Wouldn't that be exciting?


CDLIC said...


I understand that tomorrow, Tuesday, October 21, is the day Lehman Brothers "credit default swaps" (CDS) must be settled.

I also have read that Lehman Brothers assets are worth about eight cents on the dollar, or credit default being 92 cents on the dollar times $400B. Those responsible for covering any default by Lehman Brothers must settle tomorrow. Since the CDS markets are so intertwined and convoluted it is not yet clear who has to pay how much.

Therefore, the question is how much effect might tomorrow have on the markets and financial institutions if those responsible for stepping up cannot?

Scott Grannis said...

I think the actual payment of the swaps is a non-issue. One of the links I had in my post on the subject was to a press release from the agency handling the swap settlement, and there it points out that the net payment due was a very tiny fraction of the notional amount.

Wednesday is the auction for the WaMu CDS. It looks to me like the market has digested all this stuff pretty well by now.

Jon S. said...

Are you concerned that despite good news on swap spreads, housing and oil bubbles bursting, etc, that the underlying strength of the world's major economies remains weak, with still more weakness to come as some analysts like Marc Faber are forecasting? In other words, if there is to be an equity rally, how strong and sustained do you think it will be?

Scott Grannis said...

It's possible this crisis could really set the global economy back seriously, but I doubt it. This crisis has been taking place primarily in the financial arena. It has impacted the economy via the intense fear and uncertainty that has been created as people contemplate the fate of our banking system. If the banking system can right itself, which it appears to be doing, then fear should dissipate and consumers should go back to their purchases and the economy will get back on its feet.

This could all happen fairly quickly, just as it did on the downside. I hope it does.