What’s the difference between spending hundreds of billions or even trillions of dollars on loans, on the one hand, and loaning out the money directly, on the other? All of the "bad bank" proposals have one thing in common: that the government buy up a huge quantity of loans of some description — and take on the associated credit risk. So why not start lending money in the real economy, especially if that can be done without taking on any credit risk?
That’s the idea of Tyler, over at Zero Hedge, who notes that companies like John Deere and Casino Guichard are issuing new bonds at spreads hundreds of basis points wide to where their credit default swaps are trading. The government — or a state-owned bad bank — could easily lend at lower rates than that, and fully hedge all the associated credit risk in the CDS market.
Politically, it might be hard for the government to get involved in the demonic CDS market. But on the other hand, the government’s money would be going straight to companies which need the money and will spend it, rather than to banks which are likely to just sit on it.
Obviously, all such hedging would have to take place on a new CDS exchange, but that’s no bad thing: it would help the exchange to get going. It would even be legal under the draconian standards being mooted by Collin Peterson, the chairman of the House Agriculture Committee, which would not only ban all off-exchange CDS trading but would also require ownership of the underlying bonds.
What reason is there to believe that this arbitrage will continue to exist even once the CDS market has moved to an exchange? Isn’t the negative basis entirely a function of counterparty risk?
The answer to that is yesbut. The real reason for the CDS basis is a kind of counterparty risk, but it’s not the counterparty risk that we normally think of in the CDS market — the risk that a bank will write protection and then go bust before it can pay out on it. Instead, it’s an illiquidity premium in the cash bond market. The people playing the CDS basis trade tend to be banks, who tend to fund their cash bond positions in the overnight repo market — and that is where their internal cost of funds has skyrocketed.
An institution with limitless liquidity, like the government, doesn’t have that problem, and can happily hold cash bonds without having to pay a hefty Libor-OIS premium. If the government were to buy credit protection from banks, the market-rate counterparty-risk premium it would charge would be much smaller than the negative CDS basis. And if it were to be buying protection from an exchange, the counterparty risk involved would be smaller still.
A lot of the discussion surrounding the stimulus package has involved setting up new state-owned banks, whether they be infrastructure banks or bad banks or whatever. Surely one of these entities will find itself able to go out and lend money to the companies who are currently having to pay an enormous illiquidity premium when they issue new debt. It will be good stimulus spending: you can be sure the money is needed. And when there’s an almost-perfect hedge for the taking, which locks in profits for the taxpayer, it would be silly not to do it.