Betting against Uncle Sam

July 25, 2011 01:38 PM

Bloomberg reported on Monday that trading in credit default swaps on U.S. Government debt had increased 57% in 2011 according to Depository Trust & Clearing Corp. (DTCC) data. According to the story the market priced in a 4.56% chance of a default by September 2016. The cost to hedge that risk climbed 17 basis points since the beginning of April to 53 bps. 

It is all kind of odd as I never would have thought such a market would be possible. And if a default happens who would pay off? And more important who would bail out those holding the losing position ala AIG’s book of CDSs in September 2008.   

Jeff (Fibonacciman) Greenblatt brings up an interesting point in his weekly technical commentary regarding the potential of default. “There are only two kinds of people in the world. Those who understand how financial markets work and those who don’t.  The problem right here is the fact that those who do understand how financial markets work can’t possibly believe the outcome of this event would fall into the hands of the people who don’t know how the markets work. In other words, the inmates are running the asylum….You see, the really smart people in this industry can’t believe the U.S. would actually come to a self-inflicted default in this situation.”

 Of course it is difficult to say who are the smart people, perhaps other than those folks earning money trading an event that most likely would prevent any economic resolution of those trades if that underlying event occurs.

An interesting aspect of this  is that it is going on while the rules for these products are still being debated.

I would think betting against a default would make sense but it all depends on the margin rules as CDSs are binary products. That mean they are all or nothing and while commodity futures can’t go to zero these can and as futures industry veteran  Neal Kottke pointed out in an interview, the appropriate margin for such a product really should  be 100%. So while it might be a good bet that the U.S. Government won’t default — either a week from now or next year if a temporary increase in the debt ceiling is passed and we have to do this all over again in six months — the CDS market may price in a much higher likelihood of such an event and those betting against it may face a huge margin call or increase in their capital requirements to hold onto to those bets.

In our poll question we ask whether a deal would be struck. The options we provided are basically: yes, no and yes but not before the market puts a scare into Congress and the President. With no deal in sight and less than a week to go that scare could be coming at any moment.

While this is nothing to toy with I kind of wish there could be a temporary default forcing a margin call on the investment banks making a market in the product. Once they are forced to take a loss a debt ceiling deal could be announced. That would be sweet justice. Of course the government would have to bail out those banks again on those losses.

About the Author

Editor-in-Chief of Modern Trader, Daniel Collins is a 25-year veteran of the futures industry having worked on the trading floors of both the Chicago Board of Trade and Chicago Mercantile Exchange.