Credit Default Swap Market Says Avoid Merrill Lynch & Pulte and Buy Brazil

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After several years of robust economic growth, the Brazilian economy has all- but-erased its reputation as an economic basket-case. Gone are the memories of chronic corruption and crippling devaluations. The once-pathetic Brazilian currency is now a paragon of strength and respectability – so much so that Brazilians prefer their “reis” to U.S. dollars.

Meanwhile, in the United States, the world’s richest country, the multibillion-dollar credit contagion expands from press release to press release. We would stop the presses if only it would halt the contagion. But the financial world is not so configured.

For the first time ever, therefore, investors consider Brazilian government bonds safer than Merrill Lynch (NYSE: MER) bonds. According to the relative pricing of credit default swaps (CDS) on Brazilian government debt versus Merrill Lynch debt, the reeling American brokerage firm is a riskier credit that the resurgent Latin American economy.

[Credit Default Swaps are a kind of insurance policy against a bond default. The greater the perceived risk of default, the more expensive the insurance – i.e. the Credit Default Swaps – would become. Declining CDS prices, therefore, would indicate declining anxiety about a potential default, whereas rising CDS prices would indicate rising anxiety about a potential default.]

Buying five years of protection against a Brazilian default used to cost much more than buying five years of protection against a Merrill Lynch default.

But now that Brazil has become as crisis-free as the U.S. financial sector has become crisis-prone, Credit Default Swap prices have flip-flopped. Merrill CDS prices have jumped above those for Brazilian government debt! In other words, CDS buyers consider a Merrill Lynch default more likely that a Brazilian default.

Maybe CDS investors have got it all wrong… or maybe the U.S. finance sector is in much deeper doo-doo than most investors believe. The “doo-doo” interpretation seems more plausible.

Credit Default Swap pricing is not necessarily indicative of future trends, but neither is it NOT indicative. For example, after presenting the following chart in the March 14, 2007 edition of the Rude Awakening (“Credit Default Swaps… and You”), we advised, “Sell the mortgage lenders… Finally, investors are beginning to recognize that the unfolding mortgage-lending crisis might be something more than a fleeting annoyance…

“Now that companies like New Century are perishing,” we concluded, “and the nation’s largest banks and brokerage firms are warning of possible ‘mortgage- related charge-offs’ demand for Credit Default Swap protection is rife. Demand for put options on mortgage-lending stocks is also very robust. As a result, insurance ain’t cheap. Then again, how often do you get the chance to buy fire insurance when you’re house is already ablaze? If the bond market is as smart as she usually is, this inferno might blaze for a while longer still.”

And indeed it has. The mortgage-lending conflagration has consumed hundreds of billions of dollars worth of asset values, both in the real estate market and in the mortgage-backed securities market. At the same time, the conflagration has scorched the careers of a few finance-company CEOs, torched the U.S. dollar and threatened the viability of numerous enterprises.

An updated version of Credit Default Swap pricing for Pulte Homes (NYSE: PHM), Washington Mutual and the Russian government shows that the market has become even more anxious about homebuilders and mortgage-lenders. Pulte Home Credit Default Swap cost five times more than Brazil Credit Default Swaps. A contrarian investor might infer from these pricing extremes that the time has come to buy Pulte and sell Brazil. Perhaps the contrarian would be correct.

But a chicken investor would conclude that the time has come to accept the verdict of the Credit Default Swap market and avoid stocks like Merrill Lynch and Pulte… even though they have already suffered mightily. A chicken would infer that the time has come to avoid obvious risks and play it safe.

Cluck… Cluck.

Eric Fry
for The Daily Reckoning Australia

Eric J. Fry
Eric J. Fry has been a specialist in international equities since the early 1980s. He was a professional portfolio manager for more than 10 years, specializing in international investment strategies and short- selling. Mr. Fry launched the sometimes-abrasive, mostly entertaining and always insightful Rude Awakening.
Eric J. Fry

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