I recently saw a chart of the price of a credit default swap on the US Treasury. http://ftalphaville.ft.com/blog/2008/07/16/14538/unmitigated-disaster-in-chart-form/
For those of you that don't know anything about credit default swaps, basically it is a contract that says I will pay you if the underlying creditor defaults. So, I substitute my credit for the underlying.
1. Company or government issues a bond
2. I write you a contract that says I will pay you if that company or government defaults (doesn't pay up)
3. The company or government defaults I pay you the value of the bond. Typically, I would pay the value of the bond minus the recovery amount from selling the firm's assets to satisfy creditors.
The notional value of credit default swaps in the world is huge; it is estimated to be $62 trillion and most people have no idea about credit default swaps. Granted most traders in CDS probably do not have huge exposures, since they are in offsetting position. Let's suppose an investment bank writes a swap on a US Treasury. The idea of this leaves me wondering what event makes the Treasury default and leaves the investment bank(counterparty) able to pay. Since the credit default swap can be seen as a form of insurance, and insurance is only as good as the insurer. We have seen trouble with the municipal bond insurers, "By January 2008, many municipal and institutional bonds were trading at prices as if they were uninsured, effectively discounting monoline insurance completely." (Wikipedia) The credible rumor of a default by the US Treasury would damage any counterparty and a default would be the financial equivalent of the end of the world.
If you buy a credit default swap on the US Treasury, it is like you are buying insurance on the end of the world. How do you price this and should you really assume anybody will be around to pay up?
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1 comment:
Interesting analysis - really, it all comes down to the credit quality of the issuer, and CDS contracts generally aren't fungible for exactly this reason. While I think the probability of the US defaulting on its debt is pretty remote, it's still important to consider that these aren't mortgage securities (there's no collateral) so they might CHOOSE to default, even if they were "able" to pay. Still though, I agree that insuring against default on a Treasury is pretty ridiculous.
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