Tuesday, March 3, 2009

Credit Default Swaps and the U.S. Debt

What are Credit Default Swaps (CDS) and what can they tell us about the risk of the US government defaulting on our national debt?

When you purchase a CDS, it is something akin to buying insurance for your investment. It's an attempt to decrease your risk on a credit derivative. As a buyer of a CDS, you pay a premium to the seller, who then is obligated under the agreement to pay you a specified amount if the credit derivative covered by the CDS goes into default. The idea is to financially protect yourself no matter what happens to the value of the loans or bonds upon which the derivative is based. If the loans or bonds retain their value, you gain from your original investment. If they loose value, you get a payoff from whoever sold you the CDS.

If used appropriately, you are able to minimize your risk. In an interesting twist, because you don't have to own the underlying credit derivative, CDSs can also be bought and sold separately, taking on a life of their own and looking a lot more like gambling than investing (not that I have a problem with gambling, as long as it's clear that's what you're doing.)

Similar to short selling, CDSs have an important role in capital markets by reflecting the perceived value of various credit derivatives and the status of the bonds and debts from which they are derived. High "premiums" for a CDS signal that the underlying loans and bonds are considered to be at a greater risk for default.

So that brings me to the latest interesting piece of news: The cost of purchasing a CDS on U.S. Treasuries is now higher than the cost of buying a CDS on Pepsi or IBM--or even government debt from France!!

Probably has something to do with all those spending bills Congress has passed lately, don't you think?

HT George Washington's. Blog

1 comment:

The Rat Cap said...

I have seen this too and talked to some people because it blew my mind. The reason is that the government can create "money" to pay its debts so I don't understand why it would trade at any premium much less at a premium to France...

To understand this completely, I think you would have to look at the covenants of the CDS which contractually define "default". Default may not be a literal stoppage of payment but might be a dollar devaluation or a credit rating downgrade or something like that.

In any case, this is a testament to the sorry state of the United States government. Thanks for showing this.