Explaining U.S. Government CDS Rates

What's going on with credit default swaps on the US government? 5-year CDS are trading in the 50bp to 60bp range these days, which implies a seriously non-negligible risk of default -- and the higher the expected recovery value, the higher the implied default risk.

Greg Ip says that "last week, markets pegged the probability of a U.S. default at 6 percent over the next 10 years"; I'm not sure where he got that figure, or why he's using decidedly rare 10-year CDS prices. But if we take a quick and very dirty look at 5-year CDS, and say they're being priced at 60bp, then that means total premiums over five years are 300bp, or $30,000 to protect $1 million of debt. If you assume a 50% recovery rate, then you're basically paying $30,000 to receive $500,000 in the event of default -- which implies a default probability of 6% over five years.

It's hard to see what would trigger such a payout, though. Dean Baker says that "a default event... could include the government temporarily exceeding its debt limit"; I don't think that's true. In order for the CDS to be triggered, I think there would have to be not only an actual payment default, but that default would have to continue for longer than the grace period.

Since US government CDS are all denominated in euros, the main loss would be a function of the dollar/euro exchange rate, which would presumably plunge in the event that the US government defaulted. But if we're assuming that the dollar recovery would be very high, and probably 100%, then it's hard to see why the US government would ever default in the first place. After all, it's not like it can't just print more money.

So I don't understand why US government CDS are trading at these levels. I don't think that zero-coupon strips are eligible as cheapest-to-deliver securities, which would definitely change the calculations, and I also don't see how in any case an event of default is ever going to get triggered. And then, of course, there are all the questions about counterparty risk -- your ability to demand collateral from your counterparty in a world where the US government is about to default might well be limited.

That said, anybody who bought protection at, say, 25bp is now sitting on a very nice profit if they close out their position. Maybe this is just a form of black swan insurance: buying US government CDS is a way of making money when everything else plunges in value. You're not really insuring against an actual default, you're just betting that if the world starts to implode, the price of your CDS is going to rise even higher.

Comments

[Smarty_Pants:]

This is the same Ben Stein who stridently argued with Peter Schiff in August of 2008 that Financials were the place to be. They were so cheap that they were 'giving them away'. As we all know, since then XLF has dropped about 50% and it would probably be worse if TARP wasn't covering up most of the financial ruins in the banking sector.

The really dangerous people are those who are smart, but not smart enough (or too full of themselves) to realize what they don't know and act accordingly. Usually they're just smart enough to put up a good front backed by little or no substance.

The (actual) smartest people I've ever met are the first ones to point out that they might be wrong about anything, even their field of expertise.

When Ben Stein starts adding cautionary statements regarding how dangerous any particular course of action might be, then I might start considering his conclusions as something more than a release of hot air from his over-inflated ego.

Jan 13 09:42 AM

[Smarty_Pants:]

Oops. Sorry. Posted on the wrong tab. Guess I'm the not so smart one today.

Jan 13 09:44 AM

[Moon Kil Woong:]

Great all we need is more CDS. We need some sort of regulation on CDS and also what is appropriate to bet on. If the government defaults on their debt the US dollar would be worthless and the Euro would also probably be in a world of trouble. In fact no currency may be worth anything except maybe the Yen.

CDS is a practice in unintended consequences. One of them is, when things go drastically bad on the CDS doomsday bets, the ability for pay-out is very hard since they usually imply complete financial catastrophe. I'm surprised banks aren't writing CDS contracts on their own bankruptcy or the odds of a nuclear war. Maybe they are.

Jan 13 10:14 AM

[wpdragon:]

CDS's won't be a bet on doomsday, they will be the cause of it.

Its nothing more than death insurance on entities the purchaser has no insurable interest in... except for their incentive to help promote the death of the entity... but they call them "swaps" so they don't have to file them with state insurance commissions because, gee whiz! the insurance commissions might void them as being illegal, immoral, and covering uninsurable risks.

Jan 13 02:09 PM