Risk Free No Longer

by on July 17, 2008 at 11:18 am in Economics | Permalink

Wow, we usually think about U.S. bonds as being the "risk-free" asset but with a credit default swap you can buy insurance on a US default and the price of such insurance is way up.
Cds

The change in price is a shock but to put things in perspective do note that the price for insuring US debt is now higher than for German debt but similar to that for Japanese and British debt.  We are still far from Argentinian levels.

Hat tip to at, in the comments to my post on the peso problem.

floccina July 17, 2008 at 11:27 am

Not to mention the big risks of inflation and a falling dollar.

Pancho July 17, 2008 at 11:34 am

Argentine.

Alex Tabarrok July 17, 2008 at 11:54 am

jdm, right, corrected.

PJ July 17, 2008 at 12:47 pm

What would qualify as a US default?

‘Sorry, we’re repudiating our treasury bonds’?

dearieme July 17, 2008 at 1:46 pm

And the Germans don’t even have a currency of their own. Or perhaps their insurance is cheap because people would be quite happy at the return of the Deutschmark.

Dan July 17, 2008 at 2:23 pm

I don’t quite understand a CDS on US government debt. Isn’t the whole point of CDS to substitute the default risk of a debtor with that of a more creditworthy entity? If the US government defaults, whomever it is that issued the CDS will probably be in quite a bit of trouble themselves

Yancey Ward July 17, 2008 at 3:05 pm

Like Joe, I would be selling these the live long day, if able. The US will never repudiate its bonds, it will simply inflate the problem away. If the worst comes to worst, and the US is forced to actually repudiate, then world civilization is belly up, and you would never have to pay off on your contract.

agent00yak July 17, 2008 at 4:54 pm

Please don’t post normalized graphs of basis points. They are quite misleading.

49 July 17, 2008 at 6:04 pm

Agree with agent00yak – that’s a terrible graph. I immediately read it as 160bps, which is absurd.

nick July 17, 2008 at 7:28 pm

If the US government defaults, whomever it is that issued the CDS will probably be in quite a bit of trouble themselves

I presume that those insuring U.S. debt buy CDS’s for U.S. debt backed by European entities, or perhaps a big oil owner like Saudi Arabia, or both, and vice versa (buy CDS’s on German debt backed by the U.S. or Saudi Arabia or both).

Barkley Rosser July 18, 2008 at 12:53 am

Actually the bond rating services have been ridiculous on this for some time, irrespective of the markets.
It has been pretty obvious ever since the Congress and President gridlocked over the budget and nearly
closed down much of the US government back in the mid-90s that a default by the divided US government
was far from a ridiculous idea.

What was ridiculous was Moody’s downgrading Japanese national debt while keeping US debt as AAA, with the
markets making it effectively AAA+++, given both the divided US government and its mounting foreign
indebtedness, with Japan’s international balance situation just the opposite.

joe July 18, 2008 at 10:26 am

To understand “events of default” you have to read the individual contract. It’s highly unlikely that missing payment by two days would trigger payment of the $10,000,000. that said, there is zero chance that the US Treasury will even be 2 days late in paying off debt in the next 10 years. I’m the biggest alarmist I know about the US Government’s balance sheet, but for God’s sake, SS doesn’t even go cash flow negative until ~ 2017, our foreign debt as % of GDP is below most major developed nations (Japan’s exceeds GDP, ours is like 40%), the Fed’s balance sheet hasn’t exploded, so there’s room to monetize debt (not that i like this option, but it’s a sure way to prevent default), etc…

Selling CDS protection on US debt is the biggest layup right now.

MW July 18, 2008 at 11:37 am

“It has been pretty obvious ever since the Congress and President gridlocked over the budget and nearly closed down much of the US government back in the mid-90s that a default by the divided US government was far from a ridiculous idea.”

Did the loan repayments really stop when the government shut down in the 90’s? I’m assuming that there’s a mechanism in the federal treasury to keep those payments going superseding the congressional budget.

Barkley Rosser July 20, 2008 at 9:25 am

joe,

Regarding Japan you have confused “national debt” witih “net foreign debt.” Not the same thing. It was indeed the rise of Japan’s national debt level to more than 100% of GDP that led Moody’s et al to downgrade its debt. However, as FDR used to say, it is not a problem “if we owe it to ourselves” (as the US did with its more than 100% of GDP national debt arising from financing our fighting in WW II). That is the case in Japan with their high savings rate. Most of that national debt is held in the postal savings banks by Japanese citizens. This is despite the interest rates on that debt being very low (with the interest to GDP ratio lower than in the US).

Their net foreign position is positive. They lend more abroad than they borrow from abroad due to their chronically surplus current account balance.

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