Hi, Erik,
This from Wikipedia:
A credit default swap (CDS) is a swap contract in which the buyer of the CDS makes a series of payments to the seller and, in exchange, receives a payoff if a credit instrument (typically a bond or loan) undergoes a defined 'Credit Event', often described as a default (fails to pay). However the contract typically construes a Credit Event as being not only 'Failure to Pay' but also can be triggered by the 'Reference Credit' undergoing restructuring, bankruptcy, or even (much less common) by having its credit rating downgraded.
So, maybe it is the potential for "downgrading" that they are dealing with here. Certainly, US debt will be downgraded at some point.
I'm hoping someone can help me understand why so much attention has been paid in recent weeks to increasing premia on CDS against U.S. Treasury debt.
I understand what a Credit Default Swap is and how it works. But what I can't comprehend is what risk, specifically, the buyers of CDS on Treasuries believe they are insuring against when the debtor in question has a printing press and the ability to monetize.
Yes, most of us have figured out that long-dated treasuries will never be paid back in real terms. But CDS have nothing to do with real terms. As long as the debt is discharged in nominal terms, the CDS never comes into play. So the purchaser of CDS on treasury debt must believe for some reason that there is a risk of the U.S. easily being able to repay its debt with freshly printed money, but for some reason choosing not to do so. I just can't comprehend how that could ever happen.
Sure, there was a very small risk of a technical default if congress failed to raise the debt ceiling in time, but that's behind us now. And even if that somehow happened, it would be temporary and short-lived. The notion that the USA would say "Yup, we just defaulted and it's going to cause the whole world's economy to collapse and we could easily solve the problem by pusing a button at the fed and printing more money, but hell, let's have some fun and just default anyway" is completely implausible to me.
And if there really were a full fledged default (what CDS insures against), the U.S. government would be completely and totally crippled and the whole world financial system would be in shambles. Why would the holder of CDS ever expect to get paid on their claim from the issuer? Surely if the U.S. gov't defaulted, there would be no money to backstop or bail out any banks, and the CDS issuer would almost certainly be at very high risk of defaulting on its obligation to pay the claim. If the issuer defaulted, what would the holder do? Sue them? How? The court system would be shutting down due to government bankruptcy.
In summary, paying good money for CDS against tresuries seems about as foolish as buying an insurance policy against global thermo-nuclear war. If the event were really to occur, the insurer wouldn't be around to pay the claim!
What am I missing here???
Thanks,
Erik