Insuring U.S. Government Debt: A Terrific Paradox

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 foreseeable 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 backyard. If the failure of Fannie Mae (FNM), Freddie Mac (FRE), AIG, Citigroup (C) or Bank of America (BAC) 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.

Comments

[{5U}:]

HAHAHAHA hillarious and oh so true

Here is a good trade idea. Sell massive amounts of U.S.A. CDS. Slice dice and package it and create a CDO.

I GUARANTEE that will make a noice risk adjusted return. EIther that or this country is no mas.

I would be a STRONG buyer of the equity tranche of the Synthetic CDO comprised entirely of selling US. default swaps!

Jan 16 02:36 AM

[bearfund:]

Start with E10m worth of gold. Short E10m T-bonds and put the proceeds in more gold. Use the E20m worth of gold as collateral for writing E10m Treasury CDS. You're paying around 2% on the bonds while you wait for either the world to end or things to get better.

Case 1, world ends. Short position closed out at zero. Value of gold in euros triples. Sell E10m of gold to pay CDS buyer. Final value of assets: ~E49m.

Case 2, reflationary recovery. Short position closed out at 8% at a cost of E6m. Value of gold in euros rises 20%. CDS declines to 20bp, close out for a nice profit. Final value of assets: ~E18m.

Case 3, freak accident. You put on the trade and somehow get hit by a falling asteroid. Positions closed out by your executor at a small loss. Final value of assets: who cares?

I think that about covers the possible outcomes.

Jan 16 03:13 AM

[Steven Hansen:]

if uncle sam defaults, the currency is worthless so you could easily pay the loss in dollars. cds on us debt is worthless.

Jan 16 04:09 AM

[User 328725:]

I've always wondered the same thing. I can't see why anyone would buy this type of protection because if the U.S. defaults it's game over, welcome to Mad Max, bend over and kiss your butt goodbye time.

If you really want to buy insurance on U.S. debt, get some weapons and learn how to use 'em! That's the insurance you're going to need.

Jan 16 06:13 AM

[User 328725:]

Aside from that, if the U.S. defaults, a ton of the paper the Fed prints won't be worth a knee-high pile of 3 day old dog doo-doo

Jan 16 06:17 AM

[Chris B:]

A policy from a foreign issuer that pays in foreign currency if the US defaults might be worth something. After all, a policy that paid in dollars would have been useful for people living in Argentina or Russia in the 90's. Perhaps a policy that paid in yen, yuan, euros, or rupee - or a basket of these currencies - would be rational.

Then again, this would not be an insurance policy, it would be a dollar-bearish forex option. You would roll it over each cycle instead of paying premiums, losing a little money most times in exchange for the risk protection. Because default has historically caused quick and massive devaluation of the defaulting government's currency, your options would suddenly be in-the-money in such a scenario, even if your other wealth was wiped out.

The second strategy for such a doomsday scenario is to use these funds to get out. Keeping a current passport, becoming fluent in a foreign language or two, and maintaining a clean criminal record are important here. With those assets you could become a guest worker - or even a citizen - in a more peaceful and prosperous country. Successful people from shaky countries have been using these strategies for years.

Jan 16 09:20 AM

[Alan von Al...:]

Must be my karma, I'm going to say the unpopular thing. An "impairment" event that triggers payment could be something relatively simple, almost trivial, like a bank holiday, or temporary insolvency of FDIC vis a vis FDIC guaranteed bonds, or losing AAA credit rating. Depends on how the contract is written and who the counterparties are. Lots of dollars are held offshore backed by commodities. I am not much impressed with the putative conundrum, that any impairment event means Mad Max collapse of civil order.or ill-defined terminal financial collapse.

Jan 16 09:21 AM

[Hefaistos:]

Thanks for a thoughtful article.

I'd say that these CDSs might have a useful function, aside of the unlikely event of a default. And that is to set a price on US risk, to provide price signaling. Actually, CDS markets are important for pricing credit risk.

This has relevance for e.g. the currency market. A higher spread on the CDS contracts might translate directly to a negative for USD.

Jan 16 11:29 AM

[Don Fishback:]

Alan, You make a valid point that the event could be perceived as trivial. But as I understand it, and I am not an expert on the specifics of the particular contracts being measured by Markit, these credit DEFAULT swaps are specific to a default-type event. A downgrade would merely require more collateral from the swap seller. And the bank holiday and insolvency of the FDIC would not impact the bonds that are being insured, unless those events are in conjunction with defaults on U.S. Treasury bonds.

I have searched for clarity as to what could cause a triggering event. As yet, I haven't found anything. So I am just going by the standard definition of what, in the past, have constituted as triggers, such as failure to pay, restructuring, bankruptcy and moratoriums.

-- Don

Jan 16 12:19 PM

[Duude:]

Who said that the insurance issuer is paying in U.S. treasuries and not Japanese debt?
And what about default? As long as the dollar remains the most widely used currency involved in world trade we can always print more paper. This would have to end when another becomes the currency of choice and others become unwilling to buy more of our debt. This is easier said then done. I don't see it happen with any country that is dependent on exports for an excessive part of their GDP. Who are they going to sell to?

Jan 16 12:52 PM

[drbob66:]

Probably no one is expecting to have to "pay out" on any bankruptcy...this is just a bunch of guys buying and selling paper (CDS's); in other words, legalized gambling. This country has far too many individuals who devote their energies and talents to essentially making bets on the price movements of practically anything. Buy and sell, buy and sell (hopefully buying at a low price and selling at a higher price...although, as anyone can see by looking at the balance sheets of MOST of our major financial institutions, these gamblers often find themselves unable to sell at a higher price...and sometimes HAVE to sell at a large loss). The U.S. financial "industry" is chock full of these gamblers (along with an equally large number of "expert" advisors and analysts that happily provide their --usually ill-informed -- opinions as to how these "investors" can most easily "maximize their returns"...for a fee, of course). I wonder how much better off this country would be if we didn't have so much of our talent being wasted on unproductive activities? Isn't there a better, more productive "investment" that could be made with the capital that's currently being devoted to gambling on CDS's? Like, maybe, investing in a company that actually makes a product? Oh well, I doubt that we'll never know, since these clowns will continue to gamble for as long as the government sanctions it. After all, it beats doing real work, right?

Jan 16 01:28 PM

[donzelion:]

Sounds to me like a forex option trade that is being relabeled as "insurance" - possibly because of foreign tax obligations. In many other countries, options and similar financial devices are taxed at one rate, but "insurance products" are taxed at another to encourage people to invest in insurance sectors.

It'd be a pretty arbitrary distinction, but it wouldn't be the first time that a whole set of items started trading due to perceived tax advantages...

Now if this is so, then the question isn't "who sells the insurance," but rather, "who buys it"?

Jan 16 03:37 PM

[morph366:]

As other contributors have said - the mystery is not so much who would want to underwrite the risk of a U.S. government default - the framework for enforcing such an insurance contract would presumably not be too reliable after such an event - but who is taking out such protection?

Jan 16 05:06 PM

[look closer:]

Finally, the last three comments hit the nail on the head --- who is taking out such protection ? I would love to see a followup to this article with the focus on those who do take out these policies. And of course it would help to hear who provides this 'insurance'.

Jan 16 05:54 PM

[nick in kyoto:]

3 Brief Comments:

(1) Toyota has had a higher credit rating than Japan's Gov't for years. And Japan's fiscal condition is far better than the US's.

(2) In a highly deflationary scenario the US could technically default on its debt -- by gov't decree -- and still pay, say, 90% on the dollar. The world wouldn't end.

(3) These swaps are margined. As default probabilities rise more money is put up. If/when the CDS seller defaults, he is out all the money already posted -- and taken to court. Buyers can win big long before default happens.

Think harder before buying those guns.....

Jan 17 09:08 AM

[Don Fishback:]

Felix noted this in his article, and User 339138 states it in point (3). As donselion noted, this is really similar to an option. But it's an option that I don't think anyone can reasonably expect to exercise. It's not like a call option on a stock where you can exercise it and get the shares. In this event, the option can only be exercised if the U.S. defaults on its debt, which, because of the intertwined nature of our global financial system, would have catastrophic consequences everywhere. So, I think people are just trading this, hoping and praying that someone else comes along to buy the CDS contract at a higher price later.

Jan 17 12:29 PM

[Don Fishback:]

Just saw this for anyone interested. Paul Kedrosky and Felix Salmon are going to have a live chat on this subject on Monday at 9 a.m. PT.

Here's link to the article at Paul's web site:
paul.kedrosky.com/arch...

Jan 17 12:33 PM

[Jake Berzon:]

Thanks odds for letting us know - that should be rather curious. It sounds like it will be a discussion of other sovereign debt default (i.e. Greece) and not specifically the US, but that's an interesting place to start nevertheless. For those who are trying to figure out the url on paul.kedrosky.com site it is:
archives 2009/01/16 sovereign_defau.html (just replace the two spaces with /).

Jan 17 12:56 PM

[Jeffrey Moore:]

As has been stated, we will just print money to pay off our t bills that are payable in USDs, I doubt that we would ever default, unless people started demanding that our debt be payable in Euros or something... Hopefully, we will finally figure out that we NEED to cut spending at a drastic pace.

Jan 17 05:33 PM

[Jonathan Hu...:]

Clearly CDS on Treasuries are just being used as a mehanism for speculation (ie will they become perceived as more or less risky) and not for actual hedging purposes.

While most of the arguments are correct in the event of an actual (or should I say theoretical default) they seem to miss this point.

Jan 17 11:02 PM