U.S. Sovereign CDS Rockets to 82 bp: And it's still very unclear who's buying this protection.

From Felix Salmon:

"Extra Credit, Friday Edition

U.S. Sovereign CDS Rockets to 82 bp: And it's still very unclear who's buying this protection.

Deutsche Bank Fallen Trader Left Behind $1.8 Billion Hole: As suspected, it was on the CDS basis trade.

Harvard Endowment to Cut 25% of Staff: That's about 50 jobs.

A new hedge fund business model: Ideas for fixing the present flawed incentives.

‘Infrastructure more helpful than tax cuts’: The IMF says that government spending boosts and tax cuts are the only thing keeping the global economy from an outright contraction.

Somali Pirates Get Ransom and Leave Arms Freighter: And the NYT gets some great quotes from one of the pirates, Isse Mohammed."

Me:

I believe that the US might default on some of its debt in the future. That's why you might want some insurance, since you might lose some part of the principal of your bond. I'd say more, but, so far, I haven't gotten a damned thing for this extra credit. What gives?

By DonthelibertarianDemocrat Posted: Feb 07 2009 00:42am ET

Me:

Response to Matt Feb 07 2009 03:32am ET

Matt, I didn't say that it was smart. However, if you've been following Martin Wolf's posts on the Spender Country/Saver Country Symbiosis, as I call it, I did, first tongue in cheek but not totally in jest, suggest that the Saver Countries could cancel some debt and the party could then continue. That way, no one will be asked to do anything unnatural or painful. But see here:

http://www.bloomberg.com/apps/news?pid=20601080&sid=aFgHlh.Dn4Lc&refer=news

By Stanley White and Shigeki Nozawa

Dec. 24 (Bloomberg) -- Japan should write-off its holdings of Treasuries because the U.S. government will struggle to finance increasing debt levels needed to dig the economy out of recession, said Akio Mikuni, president of credit ratings agency Mikuni & Co.

The dollar may lose as much as 40 percent of its value to 50 yen or 60 yen from the current spot rate of 90.40 today in Tokyo unless Japan takes “drastic measures” to help bail out the U.S. economy, Mikuni said. Treasury yields, which are near record lows, may fall further without debt relief, making it difficult for the U.S. to borrow elsewhere, Mikuni said.

“It’s difficult for the U.S. to borrow its way out of this problem,” Mikuni, 69, said in an interview with Bloomberg Television broadcast today. “Japan can help by extending debt cancellations.”

So, at least one other person gets the point. Could the US unilaterally do this? I don't know. But in our world, where people invest in the oddest contraptions, I can imagine someone thinking that they're way ahead of the curve on this.

Now, do I at least get extra credit for throwing this explanation together, plausible or not?

By DonthelibertarianDemocrat Posted: Feb 07 2009 11:55am ET

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"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.

"For now, of course, Macro Man has to scratch his head at some of the pricing out there. "

MacroMan sees good news out there:

"Macro Man remains dubious that this is the appropriate conclusion. His view is that the actions of both the Fed and the Treasury, however ineptly communicated (here's lookin' at you, Hank!) simply represent the principle of Ricardian equivalence at work."

I guess he means that there will be no increase in demand.

"The past few decades, but particularly the past few years, have seem enormous rise in private sector leverage....both through traditional lending and derivatives contracts. The past couple of years have seen the total face amount of outstanding derivatives contracts increase at a run rate of $150 trillion dollars per year, according to the BIS.

And guess what? The value of that stuff has gone down. Financial institutions and private sector actors have learned the hard way that assets may come and go, but debt lasts forever. UBS estimates that banks need to raise an additional $1 trillion in capital to offset the amount of forthcoming losses and writedowns."

It seems he believes that banks, are, in essence, saving. I don't read that chart in quite the same way. I see a lot of derivatives yet to be worked out.

"At the end of 2007, Citigroup had more than $2 trillion of assets on their balance sheet. That number will be a lot lower by the time all is said and done. Not that US banks have a monopoly on absurd leverage, of course; at the end of last year Deutsche Bank had over €2 trillion of assets- that's 80% of German GDP. Again, trends in that figure are only going one way moving forwards."

The banks are saving.

"So in Macro Man's view, any dollars "created" by the Fed to expand its balance sheet (and let's not forget, they have yet to really crack out the printing presses by not sterilizing their asset purchases) will merely partially offset dollars lost through de-leveraging and the implosion of the shadow banking system, rather than finding their way into new the purchase of fresh turds."

There's no increase in demand.

"The impact of these programs will, in Macro Man's view, only submarine the dollar once the crisis is resolved and domestic demand begins growing organically again. That seems likely to be several years away, for there is another kind of Ricardian equivalence at work- the ballooning of the US budget deficit should be offset by a sustained rise in the US private sector savings rate.
I don't see how it's different, except that it's individuals saving money, as opposed to banks paying down debt.

"For now, of course, Macro Man has to scratch his head at some of the pricing out there. US sovereign CDS have ballooned out.....
...and are now trading merely a dozen bps below BNP! Are you kidding me? The US government (a flawed beast, to be sure, but the owner of a printing press for the current world reserve currency) a similar credit to a French bank? Puh-leeeez....."

Well, here's where MacroMan's thesis goes a bit sideways, because the CDSs on US Government Bonds, which I've already talked about today, are saying that the risk of default is worse. From MacroMan's point of view, they should have stayed the same, and, quite frankly, be getting better.

"His methodology has served him well this year, and he has little intention of becoming another footnote when the history of today's Ricardian equivalence is written."

Good luck to MacroMan and Casey Mulligan.

"The cost of hedging against losses on U.S. Treasuries surged to an all-time high"

The other day I wondered if you could bet, excuse me, invest in a CDS that dealt with government bailouts. I was trying to be amusing, at least to myself. By the way, I'm going to post some of my modest attempts at humor today just to give my self a break from this very troubling situation we find ourselves in. And yes, I understand that things are much worse in the Congo, say, and I wish I had some ability to make sense of that situation, but I don't.

Turns out you can bet on the bailouts, in a way. From Bloomberg:

"The cost of hedging against losses on U.S. Treasuries surged to an all-time high after the Federal Reserve’s new $800 billion effort to combat the financial crisis raised concern about how the ballooning debt will be funded.

Benchmark 10-year credit-default swaps on U.S. government bonds jumped six basis points to 56, according to CMA Datavision prices at 12:20 p.m. in London. The contracts have risen from below two basis points at the start of the credit crisis in July 2007.

“There is a lot more money to be spent and it is not clear how it is going to be financed,” said Tim Brunne, a Munich-based credit strategist at UniCredit SpA. “Credit spreads don’t reflect expectation of default, just the uncertainty over the enormous cost to the government.”

So, you can buy a CDS on US Bonds. If the swaps don't deal with default, then what do they deal with? Inflation? Not getting all of your principal back? However, here Derivative Dribble is correct. You can use the information on the CDSs to help determine what the risk of the underlying product not paying out is, and so have information on what investors, people with real money, are thinking about the product's future. In this case, US Bonds. Today's conclusion is that the financial health of the US government seems a bit worse.

Now, you might say," Well, we're borrowing a lot of money, so, it should be worse". Yes, but that determination also includes an assessment of ablity to pay, so it doesn't automatically have to go up if it's simply a matter of borrowing more.

"The Fed’s new plan to kick-start markets for loans to students, car buyers, credit-card borrowers and small businesses means it will be taking on credit risk by buying debt. The central bank pledged to purchase as much as $500 billion in mortgage-backed securities as well as up to $100 billion in direct debt of Fannie Mae and Freddie Mac, the world’s two largest mortgage buyers, and Federal Home Loan Banks.

“They are loading their balance sheet with credit risk,” Brunne said in a phone interview. “Where does all the money come from?”

No fancy answers here. The money comes from the taxpayers, if it ever comes. Obviously, Mr.Brunne sees the buying of real debt as risky, as do I. It's true, some or much of it might get paid back, but the same is true of Junk Bonds, which are paying a decent rate of interest right now, but we don't all go out and buy them. At least, I don't.

"The cost of five-year contracts on Treasuries rose 3 basis points to 50.5, after earlier trading as high as 52, CMA prices show. That’s higher than the debt of Finland, Germany and Norway, according to data compiled by Bloomberg. "

It looks like the short term prospects upon receiving this news are better than the long term prospects, but it also means we have a higher default possibiblity, according to this, than the three countries mentioned above.

"Credit-default swaps, contracts conceived to protect bondholders against default, pay the buyer face value in exchange for the underlying securities or the cash equivalent should a country or company fail to adhere to its debt agreements. A rise indicates deterioration in the perception of credit quality; a decline, the opposite. "

So, the CDS does seem to include terms for partial payment on the bond.

"Contracts on Treasuries are quoted in euros. A basis point on a credit-default swap protecting 10 million euros ($13 million) of debt from default for five years is equivalent to 1,000 euros a year. "

In case you want to buy some, figure in Euros.

"The cost of default protection in corporate credit markets was little changed in Europe today. The Markit iTraxx Europe index of 125 companies with investment-grade ratings was unchanged at 168 basis points, JPMorgan Chase & Co. prices show. The Markit iTraxx Crossover Index of 50 companies with mostly high-risk, high-yield credit ratings was rose 2 basis points to 877. "

CDSs on Corporate Bonds, however, are perceived as having the same risk as yesterday.

"Contracts on the Markit CDX North America Investment Grade Index of 125 companies in the U.S. and Canada declined 12 basis points to 241 at the close of trading in New York, according to Barclays Capital. "

Here, I guess, the risk was percieved as less on CDSs of Coroporate Bonds.

The bottom line is that the risk of default by the government rose, while that of companies declined. I guess that the companies might be helped out by the government's largess. On the government's side, lowering the price of borrowing for companies would be a good side effect of the plan just announced, that being the Fannie/Freddie infusion and TALF.

If you want to, you can now bet on whether or not these loans, investments, bailouts, will ever be paid back in full by our government. I should keep an eye on these, at least.

I actually try and get links to keep track of these quotes, but a lot of them cost money, and, my site, is, well, unremunerative.