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What's Your Point?

posted by Stephen Lubben

Over the past year there have many, many articles about the perils of our nation's debt load, and I've been largely context to see these dispatched by that other New Jersey professor.

But now the WSJ has entered my territory, arguing in a recent personal finance column that the CDS market shows that US government debt is not as safe as many might think, because there is a positive price to be paid to protect against the risk of default. This argument represents a failure to do much hard thinking about what exactly a CDS contract written on US government debt represents.

For one thing, if you are buying US government CDS to protect against a full-blown failure to pay, I suggest you need to do some thinking about counterparty risk. Certainly no domestic bank is going to be able to perform under these circumstances, and I'd have some doubt about any bank performing on a CDS contract in a situation where the US has repudiated its debt. Of course, for a country like the US that borrows in its own currency, the risk of such a default is minimal, since the country always has the option to pay, albeit an option that comes with some serious side effects for the domestic economy.

But if CDS is largely worthless protection against a full default, why does the market exist? I've wondered about this a lot, but the best explication I've heard is that US government CDS provides protection against a technical or political default. For example, what if a filibuster delays an increase in the debt cap, leading to a few days' delay in paying off some maturing debt? This strikes me as a situation where a protection buyer might actually expect to collect, particularly if they carefully select a non-US counterparty.

The question, of course, is whether individual investors should spend too much time worrying about this, since a few days' delay in payment represents a very small loss to them. The WSJ article essentially acknowledges that the answer is "no." The article closes with the observation that "[f]or investors, the greatest danger is not that America could formally default on its debts, it's that the government may informally default by unleashing inflation." Okay, but what does that have to do with the CDS market? And what should we imply from the CDS market's failure to include "printing money" as a credit event in sovereign CDS contracts?

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Comments

"Certainly no domestic bank is going to be able to perform under these circumstances".Lack of understanding of CDS contract by people who claim to understand finance is truly scary.

CDS is a MARGINED product. If you bot protection from a bank and it starts to move wider, the bank will post collateral to you on DAILY basis represnting the NPV of the CDS contract outstanding. By the time CDS triggers you will havee MOST of the NPV already paid out to you by the counterparty. There is, of course a gap risk, but that's obviously not what you were talking about.

If the CDS is fully collateralized, and the collateral is held by a very stable 3rd party, I'd agree with this comment. In the future this might be so, but historically not so much.

Also, USA protection is denominated in EUR and so does have an implicit 'printing money' aspect to it. In fact between the USA and JPY (in USD) protection markets recently one could make an argument for implying a devaluation of the dollar premium from these spreads...

RE: The issue of margin / collateral on CDS. If they are exchange listed with realistic values posted for settlement/margining purposes each day, with the
exception of gap risk they are safe. Subject to the solvency of the clearing house, of course. But those seem to me to be problems that are totally insurmountable. If (when) the US repudiates paper money debt in one way or another (by lopping three zero's off the end and renaming it), it would do
so on a Friday before a three day weekend. The ensuing gap would be enormous.
Margin does not equal full collateralization. The latter would make the instrument not worthwhile either buying or selling. Margin is just that. MARGIN -- only a percentage.

Margin--short of full collateralization--is pretty well understood not to solve the problems with CDS. Look at any chart of CDS prices, like http://finpi.wordpress.com/2008/09/18/credit-default-swap-update/

In normal conditions, they trade within a small range, without too much volatility; they basically look like a stock price. Then, if something bad happens, they go up by a factor of five overnight.

Default tends to be unexpected, because an entity that's about to default will benefit from hiding that fact for as long as it possibly can. This means that a margin requirement might save you the two hundred dollars as the CDS price goes from 100 to 300, but that you'll still lose the $10,000 when they finally default (and your counterparty fails).

CDS protection on US dollar debt issued by an entity that can print US dollars seems absurd to me. It would be interesting to see an interview with whoever is buying these things, and their explanation of why, if they have so little faith in the US government, they still choose to hold US dollars.

Is it just stupid rich people? This seems like an excellent product for the private bankers; it makes them look prudent, and they know their bank will be a smoking hole long before they would ever pay out.

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