Making sense of the market in US CDS

By Felix Salmon
October 3, 2013

Matt Levine had an excellent post last week on the bizarre market in credit default swaps on the USA — a market which people only ever look at during times of crisis or potential crisis. The nihilists are out in force today, using this market to confirm their priors, but the problem is that it’s very, very hard to look at US CDS, or to look at the yield on short-dated Treasury bills, and draw anything much in the way of meaningful conclusions.

One reason why is that Treasury bills are unique in many ways, including the weirdest way of all: as worries about the creditworthiness of the US government increase, the price of Treasury securities tends to go up, rather than down. Even if the US hits the debt ceiling, that won’t hurt the price of US debt; instead, general nervousness will only cause investors to flow into Treasuries and out of riskier assets. Which is to say, out of everything else.

And although Levine has managed to piece together a scenario under which a temporary technical default on US debt could cause a real payout for holders of US CDS, I don’t think that scenario really explains the price action either. The problem with it is that the government would still need to miss an interest payment on its Treasury securities, and there’s no way that it’s ever going to do that, whatever happens to the debt ceiling.

Think about it this way: if I roll over my debts, then my total debt does not actually increase. So if a T-bill is coming due today, then the government can pay it off in full, and issue a new T-bill, without increasing its total indebtedness. It’s true that a failure to raise the debt ceiling would prevent the government from funding its expenditures with new borrowing — although John Carney makes a good case that the government could just issue Obama Bonds instead.

The government still receives substantial tax revenues every week. So although the government would have to live within its means, spending no more than it got in revenues, its revenues would still be far greater than the total amount of debt service. And with Jack Lew (or anybody else, really) as Treasury secretary, you can be sure that debt service payments would be priority number one. US government payroll — especially for the president and Congress — would probably be the first thing to get cut; the armed forces might be next, just to place maximum pressure on House Republicans. Then Medicare and Medicaid, maybe — the doctors and hospitals providing those services would just have to wait until the debt ceiling got raised before they received their checks. Failing to meet any of those obligations would not be considered a debt default, and would not trigger CDS.

So what’s going on in the odd corners of the financial markets which are suddenly receiving so much attention? The simple answer is that they’re trading markets. They don’t only go weird when the debt ceiling approaches: something similar happened back in January 2009. And here’s what I wrote back then:

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.

No one knows exactly how high CDS rates would go if we pierced the debt ceiling, but it’s a reasonable assumption that they would go higher than they are now, even if (as is almost certain) they never pay out a penny. The US CDS market is a speculative, greater-fool market: the trick is to buy at a low level, and then sell at a higher level. A bit like bitcoins, really. If you think that the debt ceiling is going to be hit, then it makes sense to buy CDS today, just because spreads are going up rather than down. The only trick then will be trying to time the perfect moment to sell.

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