by Houghton and Atkeson 09/29/08
OFF-BALANCE-SHEET DEBT
About 10 years ago, a way to trade put options on debt emerged. This market is called the credit-default-swap (CDS) market.
Originally, it was designed to be an insurance program for lenders. For example, if we loaned Wachovia Bank (WB) $1,000,000, we could go to an insurance company like American International Group (AIG) and pay a premium of about $3,000 a year to protect our principal.
If Wachovia -- whose banking operations were just scooped up by Citibank (C) -- defaulted, then AIG would pay our $1,000,000 back to us, much in the same way an insurance company will pay you for your lost home if it is destroyed by fire.
In 2005, large hedge funds realized they could buy credit-default swaps for low premiums and, if the companies defaulted, receive large amounts of cash. These hedge funds did not originate a loan and seek to buy insurance; they simply bought a CDS.
Essentially, they had a put on the debt of a company.
If the company did well, the hedge fund would lose its premium paid. If the company did badly, then they would receive a ridiculous amount of money.
Even if the company did not go out of business, the price paid for the debt insurance policy would rise (i.e., the spread would widen) and they could sell their policy (CDS) for a profit.
More Trading Ideas
In spring 2007, institutional investors could pay as little as $3,000 annually to protect $1,000,000 worth of Lehman Brothers (LEHMQ) debt. What a great investment when Lehman collapsed! Yet, what a problem for those companies who underwrote those insurance policies (CDS) on LEH!
A decade ago, the CDS market was about $1 trillion. Today, it is about $72 trillion in notional dollars (although there is some double-counting and other complexities). It is all off-balance-sheet. It is not regulated. It is much bigger than the total debt load of the United States that is on-balance-sheet.
For comparisons' sake, the market capitalization of all publicly traded companies in the world is slightly less than $50 trillion.
NUTS AND BOLTS
American companies -- run-of-the-mill, S&P 500 (SPX) non-financial-sector companies -- use short-term debt to fund their daily operations. This debt typically carries terms of 90 days or less.
This short-term debt (i.e., working capital to fund operating activities) comes from money-market funds. Money-market funds have been able to offer investors slightly higher yields than Treasuries because they primarily buy short-term corporate debt.
Because the companies are large, have been around for years and the debt is short-term, money markets have been considered very safe.
Dawn Pennington
Read This Before You Buy Another Stock
A savvy stock position can start with a single options trade.
This technique can help you breathe a sigh of relief as it aims to relieve a 'choking' portfolio.
If you are familiar with buying calls and puts, we'll show you how to buy them even cheaper.
Anatomy of a Stock Option Ticker
Option tickers may look like a bowl of alphabet soup to you, but each letter means something.
You don't have to short stock to put a bearish bet on the table -- but the path to profits comes with different levels of risk.
