Default-Day is not at hand but there are casualties

July 27, 2011 02:31 PM

The other day we pointed out how a market was developing for credit default swaps on U.S. government debt. The Bloomberg story which we referred to indicated that the market was pricing in a higher likelihood of a default and how volume had grown in the contract as more institutions looked to hedge their exposure to such an event.

While interesting, what perplexed us given the scope of government and Federal Reserve activity over recent years, is how the mechanics of such a transaction would play out. While minor fluctuations in this CDS could be hedged and traded, if a real default becomes likely it is doubtful the markets would be allowed to decide.

 And while most analysts discount an actual default happening, many also point out that going into default is not the only thing that can cause damage to our economy and U.S. standing. In fact damage is accruing the closer we come to the ledge without a resolution. In our poll we are asking what is likely to happen with the debt ceiling debate. The overwhelming response has been that there will be a deal but not before the market throws a scare into the politicians. We may be seeing the first signs of such a scare as the CME Group raised margins on Treasury futures and yesterday announced that they were increasing the “haircuts” given to Treasury products used as collateral at the CME clearinghouse.

While in both cases, CME pointed out that the move was part of a “normal review of market volatility to ensure adequate collateral coverage,” what they are reviewing is volatility in the market, which is subject to fundamentals such as if the U.S. government defaults on its obligations.

As of today’s close the Dow Jones Industrial Average is down nearly 400 points for the week. While it is always dubious to try and apply cause to market activity, it is a fair bet that the market is watching this debate.  

 And the fact that a significant political faction is pushing the matter — and even appear to be rooting for default — has to worry folks counting on the solidness and security of U.S. government debt. And it is still the gold standard. The dollar has been weakened for more than a decade but when things begin to look very bleak there continues to be a flight to quality towards U.S. assets. How long will that last when a portion of our political leadership see a technical default as a positive?

If there is a downgrade, that only makes matters worse. It will decrease our options not increase them.

Higher capital requirements could force end users to lighten positions as it takes more capital to back those positions.

An interesting blog post yesterday in Naked Capitalism pointed out that at one point in 2007 AAA rated collateralized debt obligations (CDOs) and asset backed securities (ABSs) were highly regarded forms of collateral and received minimal (2%-4%) haircuts from clearinghouses. When those products were exposed in 2008, they could no longer be used for collateral and that helped cause a huge exodus from the markets. I can’t see a scenario where the haircuts on U.S. Treasuries go to 95% as was the case with AAA CDOs, but every increase in the haircuts has an affect. It pulls capital from other sources. As we mentioned, damage is accruing.

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.