"Who on earth actually buys something that pays if and when the U.S. defaults on its debt? "

In essence, I agree with this post, but I'll give this one try. From Don Fishback's Market Update:

"Insuring the Uninsurable January 15th, 2009

A few days ago, Felix Salmon had a provocative post at portfolio.com, where he notes that the price of credit default swaps (CDS) on U.S. Treasury bonds is rising. Somebody is writing an insurance policy on U.S. government debt, and the price of insuring that debt is going up. And I love insurance, because of its nearly identical properties to options.

At first glance, the price rise makes perfect sense. As something becomes riskier, the price of insurance also rises. And with all that borrowing, and with the extreme slowing of the economy, I think it’s fair to say that U.S. debt is indeed riskier than it was before. [I’m talking about repayment risk, as opposed to interest rate risk.]

But here’s what Felix’s column provoked me into thinking, and he touched upon it when he mentions counterparty risk near the end of the article. Who on earth actually buys something that pays if and when the U.S. defaults on its debt? And who sells an insurance policy like that?

More important, if the price of the CDS goes up, what does the counterparty put up as collateral? Typically, you can put up T-bills as collateral. But T-bills are what’s being insured here.

Equally important, what does the credit insurance policy buyer expect to collect if the U.S. government debt goes into default? Think about it. If the U.S. defaults, what would the world be like? In what condition is the global financial system going to be? This may be naive of me to think this way, but if I were a betting man, my guess would be that, if things get so bad that the U.S. government defaults, the world financial system is going to be a complete and utter mess. And I seriously doubt that any insurance issuer is going to be able to survive and actually pay that claim.

But isn’t one of the underlying tenets of buying insurance to make sure that the insurance company can pay a claim if need be? Don’t you need to be sure that the counterpary can write the check if catastrophe strikes? It seems to me that would mean that the insurance seller has to have a claims-paying ability that exceeds that of the insured.

In the instance of insuring U.S. government debt, I’m not sure there is any insurance company that can make that claim. I mean, if the measly mortgage market can take down banks and insurance companies worldwide to such an extent that the U.S. government has to step in and rescue companies that wrote CDS contracts based on the mortgage market, in what shape do you think those financial companies will be if the U.S. government defaults?

To me, this is a terrific paradox. You want insurance, but there is no way to insure this kind of catastrophe because if the catastrophe happens, the seller of the policy goes down with the rest of the world — at least for the forseeable future. This is not Equador we’re talking about. This is a 5-year policy on U.S. government debt, and I don’t think that the world will be in a position to withstand the bankruptcy of the United States anytime in the next five years without financial armageddon.

That’s not to say that we’re going to see financial armageddon. It’s just to point out the futility of this type of insurance purchase. That’s because if the U.S. government goes belly up sometime in the next 5 years, I don’t think there will be that many people worried about getting a check. I think they’ll be more worried about riots in their own back yard. If the failure of Fannie Mae, Freddie Mac, AIG, Citigroup or Bank of America would have been so bad that they had to be rescued because allowing any one of them to go under would have caused the global financial system to collapse, imagine what would happen if the U.S. government itself defaulted on its debt! Not only would the government implode, those institutions that the government guarantees would also lose their financial guarantor. They, along with the FDIC and a host of other programs like it would also collapse. The question then becomes, would government checks be any good? Social Security? Medicare? Paychecks to soldiers? Would those checks bounce? Would there be any banks remaining to take the checks to get them cashed? If you actually received a check from the company that issued the CDS, would that check clear? The banking system as we know it will have probably collapsed so that checks wouldn’t be anything but worthless pieces of paper. And think about this. If the government of the world’s largest economy and military power defaults in the next five years, what do you think England, Germany, China, Russia, Saudi Arabia and every other country on earth is going to be like?

My point is this. Buying insurance on 5-year U.S. government debt is probably the stupidest thing anybody could possibly do because the company issuing the policy wouldn’t survive the financial catastrophe that the world would be in. And even if it did, getting paid is probably a moot point, as money would likely be worthless at that point anyway.

If you’re really worried about the U.S. government defaulting on its debt, keep that money you’re spending on the CDS contracts and instead invest in guns, ammo, and farmland with a good water supply.

– Don

P.S. - Paul Kedrosky has a similar (but not identical) point of view on this."

Okay. What if the default is only partial? In other words, the US Government lowers the value of its bonds. That wouldn't be a total wipe-out, either of the US or the bonds. That's my rationale. I have no idea if it works.