Bankruptcy

What's Your Point?

By Stephen Lubben

Over the past year there have many, many articles about the perils of our nation's debt load, and I've been largely context to see these dispatched by that other New Jersey professor.

But now the WSJ has entered my territory, arguing in a recent personal finance column that the CDS market shows that US government debt is not as safe as many might think, because there is a positive price to be paid to protect against the risk of default. This argument represents a failure to do much hard thinking about what exactly a CDS contract written on US government debt represents.

For one thing, if you are buying US government CDS to protect against a full-blown failure to pay, I suggest you need to do some thinking about counterparty risk. Certainly no domestic bank is going to be able to perform under these circumstances, and I'd have some doubt about any bank performing on a CDS contract in a situation where the US has repudiated its debt. Of course, for a country like the US that borrows in its own currency, the risk of such a default is minimal, since the country always has the option to pay, albeit an option that comes with some serious side effects for the domestic economy.

But if CDS is largely worthless protection against a full default, why does the market exist? I've wondered about this a lot, but the best explication I've heard is that US government CDS provides protection against a technical or political default. For example, what if a filibuster delays an increase in the debt cap, leading to a few days' delay in paying off some maturing debt? This strikes me as a situation where a protection buyer might actually expect to collect, particularly if they carefully select a non-US counterparty.

The question, of course, is whether individual investors should spend too much time worrying about this, since a few days' delay in payment represents a very small loss to them. The WSJ article essentially acknowledges that the answer is "no." The article closes with the observation that "[f]or investors, the greatest danger is not that America could formally default on its debts, it's that the government may informally default by unleashing inflation." Okay, but what does that have to do with the CDS market? And what should we imply from the CDS market's failure to include "printing money" as a credit event in sovereign CDS contracts?

Full post as published by Credit Slips on December 10, 2009 (boomark / email).