CDS on U.S. Treasuries: I don't get it...

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Erik T.'s picture
Erik T.
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CDS on U.S. Treasuries: I don't get it...

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

 

horstfam's picture
horstfam
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Re: CDS on U.S. Treasuries: I don't get it...

Hi, Erik,

This from Wikipedia:

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.

 

Erik T.'s picture
Erik T.
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Re: CDS on U.S. Treasuries: I don't get it...

horstfam,

That's an excellent point... When I heard all this talk about CDS on treasuries, I was thinking in terms of CDS used to insure default risk. You are correct that a downgrade is a much more plausible scenario, but I haven't heard anything about the CDS in question being used to insure against that risk. As the Wikipedia entry says, that's a "much less common" use of CDS, and I would think that detail would have been disclosed if that was the angle.

All this begs another point: I'm equally confused about why Moody's is suddenly talking about downgrade risk. They say it's because of the huge deficit, but for all the reasons outlined in my first post, I don't think the size of one's expenditures have anything to do with default risk when the borrower has a printing press and the ability to monetize at will. So another way to pose the question would be "Why in the world would anyone downgrade the AAA rating of U.S. treasuries when all the Gov't has to do to avoid default is print up some fresh money to service the debt?"

Thanks,

Erik

Thomas Hedin's picture
Thomas Hedin
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Re: CDS on U.S. Treasuries: I don't get it...

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.

The debtor may have the ability to monetize but does not excersize that ability.

Erik T.'s picture
Erik T.
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Re: CDS on U.S. Treasuries: I don't get it...
Thomas Hedin wrote:

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.

The debtor may have the ability to monetize but does not excersize that ability.

Yes, I understand that's what it would take, but I cannot comprehend a situation where the US Gov't would choose to default rather than monetize. And if they ever did, I seriously doubt the counterparty would be around to pay the claim.

I still feel like I'm missing something. Smart people are obviously concerned about this or they wouldn't be spending good money on CDS "protection". That means they are conceiving of a scenario where the gov't would choose to allow a default to occur, since unlike other borrowers, they can never be forced to default when they could monetize instead. I just can't fathom what that scenario could be.

Erik

 

Farmer Brown's picture
Farmer Brown
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Re: CDS on U.S. Treasuries: I don't get it...

ET,

Could you post a graph of US CDS rates so the rest of us can see what you are seeing?  I don't have any answers, but seeing a graph might help.

cmartenson's picture
cmartenson
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Re: CDS on U.S. Treasuries: I don't get it...

Erik,

I don't get it either.  If we assume that the Fed and the government are a single entity, then there's really no way to default on debt that's denominated in your own currency.  You can just print up the required payments any time you want.  Sovereign debt defaults are (as far as I know) always due to having debt denominated in something other than your home currency.

The CDS premia, therefore, are a bet that the Fed and the fed are not monolithic and may part ways. 

This seems extremely unlikely to me.  If I were in a position to sell Treasury CDS I'd sell them with 100x leverage with very little concern, although probably through an offshore account, just like the big boyz, you know, just in case.

Ken C's picture
Ken C
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Re: CDS on U.S. Treasuries: I don't get it...

This is one of the reasons that I like this site. I certainly can't answer the question but it gives me something to think about that never would have occurred to me. My education continues.

Erik, thanks for posing this question and I hope someone here can shed some light on this.

 

Ken

 

Davos's picture
Davos
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Posts: 3620
Re: CDS on U.S. Treasuries: I don't get it...

The entire CDS thing reminds me so much of the betting houses they had pre GDI. You could bet on a game or the weather. Legalized gambling at our expense.

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