Bank protection has gotten very pricy during the past month, despite the Geithner plan. The cost of insuring Citigroup’s 5-year senior debt has jumped from LIBOR +300 bps to LIBOR +600 bps between the end of January and the end of March, while Bank of America has jumped from +200 bps to +400 bps.

Given the sharp rally in bank equity prices, this appears out of line. From a longer term perspective, though, the typical “hockey stick” pattern applies to the relationship between bank equity prices and credit spreads. As the equity price approaches zero, that is, the obligor’s option to default gets closer to the money, the price of the option (reflected in credit protection) rises vertically.

Bank stocks, in short, still are trading at option value. At such low levels for bank stock, option values rise precipitously, and arbitrage becomes interesting. Hedge funds are buying protection while buying the stock (or buying options on the stock. That strategy expresses a simple thought: either the stock price will go up considerably once the market decides that Citigroup or B of A is a going concern, in which case the cost of credit protection will have been cheap insurance; or the bank will fail, in which case credit protection will pay off, and the cost of the stock will have been a cheap option.

Holders of Citigroup preferred, scheduled to be converted into common equity at $3.25, cannot hedge on the equity market, because there is no stock available to short. Some preferred holders are hedging with credit default swaps instead. But that is a minor contributor. The key driver of credit default swap spreads is the perception that banks either will go up a great deal or go down a great deal.

As I said earlier, Citigroup is like Schroedinger’s Cat, in a superposed state of being dead and alive at the same time.

Citigroup Stock Price vs Credit Protection, Past 12 Months

A simple way to think about the implications of the hockey-stick diagram described by the equity-credit scatter graph above is how important volatility is. The volatility sensitivity of an option increases as it gets closer to the money. Credit default swaps are an option, and the extreme volatility of bank stocks makes options more valuable. Again, they will either go up a lot or go down a lot. Volatility reconciles widening credit spreads and higher stock prices.

This entry was posted on Tuesday, March 31st, 2009 at 6:59 am and is filed under General. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.