The easy answer is that the markets are panicking. Boy was I wrong when I said on Monday that I thought "the big 700-point down days are behind us". If the stock market plunges, then CDS gap out; there’s a very strong correlation there. On a fundamental basis, high volatility on the stock market means increased tail risk, and buying CDS is one way of protecting against tail risk.
Could the increased spreads be a sign that investors are starting to use the banks as counterparties again, and are hedging themselves in the CDS market? That’s probably a stretch, but I suppose it’s possible.
I do think that Megan’s put her finger on something important: the rise of CDS as a credit-market indicator and as a hedging device is acting as a brake on any moves back towards trust and liquidity. Back in the olden days, individual banks all made their own determinations of whether Morgan Stanley was trustworthy. Now, they just look at where the CDS is trading, and decide that it isn’t: a classic example of a vicious cascade.
More generally, in these days of volatility and hedge-fund squeezes, if a certain market move doesn’t make any sense at all, there’s a good chance that’s exactly what’s going to happen. The government’s backstopped too-big-to-fail banks, including Morgan Stanley? Great! Watch those spreads gap out to 480bp!
Maybe the market will simply not accept Morgan Stanley as a counterparty unless or until it’s nationalized. I’m sure that at this point John Mack would be quite happy to sell out to Treasury at just about any price — and MUFG would be happy too, given that they’d then essentially be getting a 10% coupon on their Treasury bonds.
The XLF financials ETF plunged more than 10% today, with Morgan Stanley doing even worse than that. Financials are about as far removed from retail sales as it gets; the old worries about financial meltdown are still just as much on traders’ minds as the new worries about economic meltdown. The world’s governments have done their best to put those worries to rest, but there was always a risk that their best wouldn’t be good enough. After today’s stock-market implosion, that risk is more real than ever.