Bloomberg is reporting that credit default swaps (CDS) on U.S. Treasury debt are trading at record high prices of 56 basis points. A market participant buying the credit default swap insurance is essentially betting the U.S. Treasury is going bankrupt. That makes no sense.
First of all, U.S. Treasury debt is conveniently denominated in U.S. dollars. It turns out that if the U.S. government needs more dollars, it can simply fire up the printing press and print some more. That would normally be a bad idea (ask Germany), but there is a strong case that printing money would be better than defaulting on debt. Of course, U.S. Treasury CDS could be different than standard CDS. They could be structured to pay out if the U.S. merely monetizes its debt, instead of defaulting. In that case, can anyone recommend a good broker for buying Treasury CDS?
The second reason Treasury CDS contracts are nonsensical: who exactly do you buy them from? If the U.S. Treasury is defaulting on debt, how bad have things gotten? Who is still in business that is willing to pay out on the insurance policy? U.S. banks that are already dependent on the government? U.K. banks that have even higher leverage than U.S. banks? How about me? I would be a great counter-party: I pay my rent on time every month, and the student loans on my personal balance sheet are backed by highly valued (ahem) intangible assets: accumulated knowledge and transformational experiences.
Outside of the People's Bank of China (who holds one trillion dollars or so of U.S. debt), there does not seem to be any credible counterparty. So who exactly is buying these things? And how do they rationalize these two objections?
Saturday, November 29, 2008
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4 comments:
If you buy the CDS contracts (even on US debt) and they increase in value because the economy is getting worse, you can sell them for a profit, no? I believe it's basically just taking a short position on the economy.
Agreed, it is shorting the economy. And you can certainly sell them for a profit (CDS rates have skyrocketed, so the value of an existing policy must have increased substantially). But the only point in owning these is the hope that they eventually pay out, right? Otherwise you are simply betting that someone else will buy them from you at a higher price, and the only reason THEY would be willing to do that is if they believe the contracts would eventually pay out. If there is no probability they eventually pay out, the value is zero, even if you can convince someone to buy them from you at above fair value, right?
Actually, there are people who believe that the US Government could default, rather than print money or raise taxes or cut spending going forward, the last three choices being politically impossible in the US.
I don't think that the bet would be that the US would totally default, but that it would pay back less than the principal the bond or whatever was purchased at. That's possible, correct.
Finally, if someone is doing it, and I saw that story as well, it must be believed by someone, if only a small enough group to constitute a market in it.
Don the libertarian Democrat
So one possible answer is that the CDS contracts are structured as "pay as you go" contracts. There are two types of CDS: one that only pays in the event of the default, and one that pays based on an underlying index (the ABX subprime asset-backed index is used for pay as you go CDS on subprime bonds, for instance). If this is pay as you go, where the CDS settles daily, paying any payments from insurer to insured, then these would make sense... but I'm not sure what index you would use... and so find this an unlikely possibility.
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