Credit Default Swaps: the World's Strangest Financial Instrument

This article, published last year (originally from Newsweek) provides some background on credit default swaps (CDS).

Why does anyone buy insurance policies that pay off only if the U.S. goes bankrupt?

The Daily Beast

Mar 16, 2010 8:00 PM EDT

Does it make sense to buy insurance against, say, a nuclear attack on Washington—if all the insurance providers' headquarters are inside the Beltway? Of course not. So why do investors buy insurance on U.S. government debt?

As many of us learned painfully during the economic meltdown, credit-default swaps are a form of insurance on financial instruments. They're contracts that pay off in the event that an entity fails to make good on its debt. You could, for example, pay a $2 premium to insure $100 in debt of, say, Lehman Bros. If Lehman goes Chapter 11, the party that sold the insurance pays $100 (or the difference between $100 and the amount Lehman can actually pay its creditors). Selling credit-default swaps is a fantastic business so long as the insured instruments or companies don't fail. That's what got AIG into so much trouble. It sold cheap protection on huge amounts of subprime mortgage bonds and collateralized debt obligations but never put money aside to make good on potential claims—leaving taxpayers on the hook to pay them off.

This brings us to the odd business of credit-default swaps on countries. In the sovereign credit-default swap market, investors can purchase (and trade) protection against the default of debt issued by governments, such as, say, Greece. In the wake of Greece's recent woes, there have been accusations that trading in CDS helped aggravate the crisis. Of course, Greece, it turns out, was never in real danger of defaulting on its debt—the notion that Europe's financial powers would have stood by while a euro-using country simply reneged on government debt was far-fetched.

So why bother with credit-default swaps on nations? CDS are a way of hedging existing positions: The value of CDS rise when the value of the bonds they insure fall. They can also be a cheap way of expressing a pessimistic view on countries' financial prospects without going to the trouble of selling short the bonds issued by the national government. Many people buying CDS for a country don't expect to collect the insurance, they expect to sell the insurance policy to somebody else. For investors, sovereign default swaps are not buy-and-hold insurance policies. They are a form of casino chip.

But in the long run, CDS only make sense as an asset class if they pay out in the event of default. This is why it's so curious that there is a market—albeit a small one—for credit default swaps on U.S. government debt. After all, if the U.S. government were to default, who would be able to pay the claims?

According to the Bureau of Public Debt, there is $8.15 trillion in U.S. government debt owned by the public. In addition, now that the United States has taken control of the failed mortgage giants Fannie Mae and Freddie Mac, the government is formally standing behind the debts of those two entities, which surpass $5 trillion. Now, let's imagine a world in which the U.S. government, lacking the will to tax or cut spending, can't scrape up the cash to stay current on interest payments and can't roll over debt as it matures. That would trigger a huge decline in the value of treasuries and mortgage-backed securities. The balance sheet of every U.S. financial institution—JPMorgan, Goldman, Citi, your neighborhood bank, the Federal Reserve, money-market funds—would be decimated. There wouldn't be a single solvent bank, insurer, or company in the United States. The large multinational banks, which have significant U.S. operations and plenty of this stuff on their books, would likewise be wiped out. Oh, and foreign holders of U.S. debt—see this list topped by China and Japan—would be toast, too.

In this dystopia, who, precisely, would be able to make good on the insurance sold on U.S. government debt? The last time we had a set of events that were supposed to trigger large-scale payment of credit-default swaps, the system basically shut down. All the investors who bought insurance on financial instruments from AIG got paid off in full only because the U.S. government bailed the company out. Who would bail out the Treasury Department and the Federal Reserve?

By definition, you can't collect an insurance payment on an entity that's too big too fail. That may help explain why the sovereign CDS market on U.S. debt is comparatively small. According to the Depository Trust and Clearing Company, there are about 415 contracts outstanding on about $2.25 billion in U.S. debt. That's tiny in comparison to the amount of total U.S. debt and in comparison to the market as a whole.

According to DTCC, CDS on U.S. government debt are the 98th-largest position in the market today, between CDS on CenturyTel and Wal-Mart. By comparisons, investors have bought insurance worth $25 billion on Italy's debt, $15.6 billion on Spain's debt, and $6.4 billion on Bank of America's. (Here's more data and pricing on CDS form Markit.)

In 2008, we learned—or should have learned—that when a systemic crisis hits, hedges and insurance are worthless when the party on the other side of the table can't make good on its financial commitments. We learned—or should have learned—that much of the innovation that was touted as a new mode of investment, and as a spur to greater transparency, liquidity, and efficiency, turned out to be just another form of reckless gambling.