Thursday, September 24, 2009

Credit Default Swaps on US Government Debt
Joe El Rady

Seriously, I couldn’t even make this stuff up if I tried: some commentators and investors seem to think that a real danger exists that the US government might default on its debt obligations. Their response: short treasuries by purchasing Credit Default Swaps on them. Ok, memo to these commentators: first, the US can print money; second, the US maintains significant taxing capacity—if you don’t believe me, simply compare average and marginal tax rates in the US to those of other industrialized countries. Finally, I would like to remind the proponents of this strategy that the buyer of a CDS accepts counterparty risk: the risk that the seller of the CDS will default before or at the same time as the borrower of the underlying debt. In such a situation, the buyer loses the seller’s protection against default by the borrower. I can’t imagine a scenario in which a treasury defaults and a CDS pays off. Let’s be honest, who sold you the CDS? Goldman? Morgan? You honestly think those firms would be around to pay your CDS in the case of a government default?