The recent widening in United States Credit Default Swap levels has gotten a lot of attention once it cleared the magic 100bps level intra-day.
As with any CDS-related news, you will get heated commentary in the blogosphere with a large perception of folks simply calling for all CDS trading to be banned. The general consensus appears to be “don’t the buyers of CDS realize that in the event of default by US, these contracts are not likely to be honored anyway?” This is Krugman’s line. Taleb chimes in with “It would be like buying insurance on the Titanic from someone on the Titanic”.
As with any heated commentary there’s bound to be a lot of misunderstanding of what this recent widening actually means and where it comes from. I’ll try to tackle this issue point by point below. For those of us with ADD (myself included) here’s a brief summary:
- Traders don’t buy CDS because they think the name will default; they buy CDS because they think the spread will widen – I make this point in my AIG post. It follows that extrapolating any default information from wider CDS spreads can be misleading
- An apples-to-apples comparison of US CDS spreads suggests that $-denominated US CDS (the standard contract that is quoted in the news is the €-denominated one) should be trading at half the level it is now, perhaps making the recent news a lot less exciting
- The standard CDS contract is sufficiently complex so that the end-game buyers of CDS can be betting on something much more innocuous than a “default” such as a restructuring of privately negotiated tiny-size debt issuance
- Sovereign CDS (US included) has actually lagged both rising financial as well as systemic risk and has only now caught up, making the recent move largely expected
CDS is not a “default” trade – it is a “spread” trade
The most important point to be made here, the same one I make in my AIG post, is that, one shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS.
I think the confusion largely stems from people viewing CDS akin to insurance. Though this is an easy analogy to make, it is, in fact, wrong. What motivates people when they buy fire insurance is that, in the unlikely case their house is consumed by a fire, they will get reimbursed. This is not what drives the CDS market.
There are two key differences between CDS and the insurance analogy:
- I don’t need to have a position in the entity’s bonds or loans in order to trade CDS on the same entity (while I do need to own the house I buy fire insurance on)
- As I mention above the vast majority of traders don’t trade CDS because of a view on default – they trade CDS because of their view on the level of CDS spreads expecting to lock in a MTM profit on the trade. Though you can probably save yourself some premium on fire insurance by installing sprinklers it’s clearly not as easy to do nor is it the primary motivation for fire insurance in the first place
Sovereign CDS is not a “fundamental” trade
I think one thing we can safely dismiss as the driver behind the widening of US CDS spreads, or in fact any sovereign spreads, in the market is any kind of fundamental view of where these spreads should be. The difficulty behind trading CDS on a fundamental default probability basis has to do with the fact that in order to put a number on an absolute default probability you need to have a firm view on: a) default likelihood, b) recovery upon default, c) devaluation of the local currency, to the extent that CDS you are trading is denominated in local currency.
Going through these in order
- It is actually difficult to have a firm view on the absolute default probability of any sovereign, particular, the United States. The fact is that developed sovereign defaults are relatively rare (outside of Spain’s relatively orderly 6 defaults within 100 years starting in the 16th century). As far as United States, my best guess is that we would need to go back to the Civil War to find a proper case of a “default”, though even here you would have to stretch. This was when the Confederacy issued cotton-backed bonds to finance the war against the North. Once the South lost New Orleans (making it impossible for South’s creditors to take physical delivery of cotton) and began to run out of cash, it became clear that it was only a matter of time before the Confederacy defaulted. By the end of the war the Confederacy’s “greybacks” were worth 1 cent on the dollar. The North refused to honor the Confederacy’s debts and the rest is history. In the 20th century developed sovereign defaults are relatively rare, especially after the World War II.
European defaults/restructurings in the 20th century (Rogoff)
- Getting a guage on expected recovery by a sovereign is not any easier. These range from the teens in Russia and Ivory Coast to 69% in Ukraine.
- Though much of protection traded on sovereigns is in a currency other than the local currency (i.e. Brazil CDS is traded in USD not in BRL), for local currency trades one has to be aware of the likely devaluation of the local currency in case of default. Those of us old enough to remember will recall the Argy peso going from 1 to over 3 in its peg to the dollar. I touch upon this in the Quanto CDS but suffice it to say that buying protection on Germany in EUR rather than USD means that €CDS levels should trade around half of $CDS levels.
The Quanto CDS
Though people like to focus on the round 100bps number, what’s mising from this is the fact that US CDS is traded in euros and that in order to do a proper apples-to-apples comparison to US-traded corporates you would need to first translate the EUR spread to a USD equivalent spread. This translation is largely a function of how much the local currency will devalued in the case of default (ignoring the small impact of rate, fx and credit volatilities and correlations). So, if you think that the dollar will weaken by 50% relative to the Euro in the case of a US default then the fair USD-denominated US CDS spread should trade around 50bps.
Do sovereign CDS trade in currencies other than the standard contract currency? In fact they do and the biggest market is in Latin American CDS denominated in local currency. If you think CDS is an “obscure” market, then this is the ultra-obscure one. It is largely driven by sovereign issuance of US-denominated debt that they swap to their local currency (in order to remove the stain of “original sin” ie non-local-ccy issuance). Normally, they would just do a simple USD/local-ccy interest rate swap. However, the trick is to do a clean asset swap instead which is simply an interest rate swap that is credit-linked to themselves which can save the country upwards of 100bps on the swap. Corporates in Europe and Latin America tend to do this “self-reference” trick as well – though it is illegal in the US.
For Latin American CDS, this local currency discount can be anything from 25-60% on 5y CDS (it varies depending on the tenor and tends to be downward sloping).
The “non-default” default
The word “default” has been thrown around a little too easily lately with respect to CDS contracts. The concept of default is, generally speaking, a very loaded one that brings to mind long bread lines, a crippled banking system and runaway inflation. In the context of CDS, the concept of “default” is a very specific one. For this reason, CDS language talks about a “credit event” rather than a “default” and can include such actions as restructuring of debt, repudiation of debt, moratorium and accleration. In summary, the following issues need to be considered in the context of Sovereign CDS.
- The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a) Failure to Pay, b) Repudiation/Moratorium, c) Restructuring. Latin American sovereigns add to this list Obligation Acceleration which was a near possibility when Hugo Chavez declared his country’s pullout from the IMF. The point here is that something like a restructuring of debt can be much more benign than an outright default (i.e. a failure to pay). So, a CDS can often price in a less dire scenario than the likelihood of “default”.
- Generally, anything counting as “Borrowed Money” can trigger a CDS credit event. This can often be a small privately negotiated loan rather than a large bond or loan trading in the market.
The Beta Issue
If you ask a Sovereign CDS trader why his names are wider today his likely response is “The index is blowing up, dude. Now do you have anything to do?” The simplest answer is that sovereign CDS is wider because everything is wider. And the simplest answer is often the right one.
Backstopping Financials
The move wider in sovereign CDS can be attributed to the expected covergence between sovereign and bank CDS spreads on the back of countries backstopping their financial systems. Countries have either bailed out certain institutions directly (Lloyd’s, RBS, ING, etc.) or have guaranteed bank deposits (Ireland, Germany,e tc.). While sovereign spreads have initially lagged the spreads of their financial systems, once it became clear that the sovereign was willing to underwrite the tail risk of their banks, it made sense for their spreads to converge. And if financial spreads refused to come down to the level of the sovereign, then sovereign levels would rise to the level of financial spreads. This was likely driven by two things: a) relative value trades of selling bank CDS and buying sovereign CDS betting on the convergence, b) continued buying of bank CDS as a hedge against bank paper. This led to sovereign CDS widening to the level of bank CDS rather than the other way around.
The Systemic Hedge
One way to understand the widening in sovereign spreads is by tieing sovereign risk to some other risk in the market that should be driven by the same views or needs. The typical buyer of sovereign CDS, apart from the marginal trader punting on Austrian eastern european exposure of the inability of Iceland to convince the world they’ve got things under control are the Investment Bank credit portfolio groups. These departments generally manage hundreds of billions of loan and derivative exposure across the bank. Their mandate is to protect the bank from an increase in non-performing loans. Normally, the counterparties to the loans do not trade in the market (either in CDS or stock) or are not liquid enough for the groups to go out and hedge in these assets. So, what they normally end up doing is buying systemic risk hedges in large size with the expectation that in the scenario a large portion of the bank’s loans goes bust, the world will be in such a state that their systemic hedges will offset the deterioration in the loan book. Though out-of-the-money S&P puts figure prominently in their hedges, in the world of credit we can look at a) super-senior spreads, b) financials spreads, c) sovereign spreads.
Assuming 40% recovery, the CDX super-senior tranche (30-100%) will be impaired after 40% of the CDX portfolio. Although it’s clearly difficult to envision the state of the world in this scenario, we can safely say the sovereign would be under pressure.
Why is U.S. Credit Risk News?
It is interesting that US credit risk is showing up on people’s radar at the moment when the “obscure” product like CDS is signaling it rather than the plain-vanilla Interest Rate Swap which trades in many multiples of volumes.
Sometime in early 2009, 30y interest rate swap yields fell below treasury yields. This price action suggested that the market viewed 30y Bank (AA) risk as safer than Treasury (AAA) risk. However, given the dire state of the Banks, this was clearly not the driver of the yield moves. What happened was that the exotics desks of the banks sold a huge amount of 2s/30s non-inversion notes to private bank investors that paid a high coupon as long as 30y swaps stayed above 2y swaps. The initial hedges done by these desks was to pay 30y swaps and receive 2y swaps. By the end of the year, rates had collapsed with 30y swaps falling more than 2y since the front end did not have as much room to rally. This meant the 2s/30s curve flattened massively causing the banks to partially unwind the hedges. In a period of poor liquidity every rates exotics desk was hitting 30y bids in size leading 30y swaps to rally beyond treasury yields.
So, though often painted as a credit risk issue, this episode was really a liquidity/technical problem.
Bring on the Technicals
Here, I briefly describe what, in addition to the above issues, could be the technical drivers of wider sovereign CDS, and US CDS in particular:
- Credit-Linked Notes Unwinds. As we all know retail investors are the best negative gamma traders. They buy high and sell low. It is not impossible that there were investors who were looking to add a few basis points to their “risk-free” trade by adding US CDS risk. It is also possible that as the crisis deepened they grew less comfortable with the risks in the trade and unwound them, suggesting that the origination desks needed to buy back the US CDS protection they initially sold, pushing CDS wider
- Liquidity in US CDS is not fantastic judging by two things: a) US dealers don’t trade it and b) the bid/offer spreads is 10bps or around 12% of the CDS spread. By comparison bid/offer spread in the CDX index (most liquid product in credit) is less than 1%. When you factor in these issues with the fact that in the current environment there are likely to be more buyers than sellers, you will see the CDS spreads widen to accommodate that
So, in summary, what do I make of US CDS widening? Well, not much apart from making it another cocktail conversation topic. Let’s revisit this issue once investors start discounting all their treasury holding by the US CDS spread… starting with China and their $1.7trn portfolio. Now that would give us something to talk about!
Nice piece. I hadn’t considered the sovereign/bank convergence trade. Also, I think you meant to write that 30yr swap rates fell below tsys.
[...] chart comes from A Credit Trader, who has a long and very useful blog entry on the subject of US sovereign CDS. He basically gives [...]
On the US and defaults:
http://www.rgemonitor.com/globalmacro-monitor/255267/was_there_ever_a_default_on_us_treasury_debt
Was There Ever a Default on U.S. Treasury Debt?
Alex Pollock | Jan 23, 2009
“As the bailouts in the current bust inexorably mount, financed in rapidly increasing U.S. government debt, one might wonder whether a default on Treasury debt is imaginable. In the course of history, did the U.S. ever default on its debt?
Well, yes: The United States quite clearly and overtly defaulted on its debt as an expediency in 1933, the first year of Franklin Roosevelt’s presidency. This was an intentional repudiation of its obligations, supported by a resolution of Congress and later upheld by the Supreme Court.”
And:
“The clearest summation of the judicial outcome was in the concurring opinion of Justice Stone, as a member of the majority: • “While the government’s refusal to make the stipulated payment is a measure taken in the exercise of that power, this does not disguise the fact that its action is to that extent a repudiation.” • “As much as I deplore this refusal to fulfill the solemn promise of bonds of the United States, I cannot escape the conclusion, announced for the Court, that the government, through exercise of its sovereign power, has rendered itself immune from liability.” So five of the nine justices explicitly stated that the obligations of the United States had been repudiated. There can be no doubt that the candid conclusion of this highly interesting chapter of our national financial history is that, under sufficient threat, crisis and pressure, a clear default on Treasury bonds did occur.”
From you:
“The nature of the “credit event”. For Western Europen sovereigns, for instance, these include a) Failure to Pay, b) Repudiation/Moratorium, c) Restructuring.”
My explanation was that the government would not default outright, but simply pay less on the debt, and that’s what’s being insured. I think that’s what you just said. Am I wrong?
Sometime in early 2009, 30y interest rate swap yields rose above treasury yields. This price action suggested that the market viewed 30y Bank (AA) risk as safer than Treasury (AAA) risk.
Just to clarify, This should be treasury yields rose above swap yields right?
Ah sorry, didnt see terwin’s comment.
Apologies! Of course I meant to say swaps FELL below treasuries which was the odd thing to witness. From now on I promise to drink even more coffee (or add less whiskey)…
Don, thanks for pointing this out. It’s pretty clear that the debt was somehow restructured which would potentially qualify under the current Restructuring clause of CDS. I wonder what the Recovery would be in this case, likely very high as I would expect in dollar terms the creditors to be paid in full (in dollars, if not in gold). This issue also speaks as to why US CDS is not denominated in USD as devaluation would add a wrinkle to fair value of protection. Though, clearly denominating CDS in euros is not that much better since the two currencies are so tightly linked.
[...] Credit Trader points out that the denomination of the CDS in Euros increases the value of the CDS significantly [...]
When you said that 100bp for an euro CDS is actually 50bp in dollar, should not you just convert the notional from euro to dollar and keep the cash flow as percentage the same i.e 100bp? Or is this another way of saying the notional value (say 1B , note that it is unit-less) remains constant and hence you just changed the cash flow rate to account for the FX rate?
I would just take two cases: I buy e10mm protection and I buy $13mm protection. On day one these amounts are the same. What happens if US defaults? eur/usd is likely to go much higher, let’s say from 1.30 to 1.80. That means in the first case I get paid out on my e10mm protection which is now worth $18mm while in the second case I still get paid out on $13mm. Clearly these notionals are different suggesting that the value of protection between them should be different as well.
Charles Calomiris talks about previous episodes of U.S. debt troubles on Bloomberg last week:
On the Economy
Calomiris Says Bernanke to Have New Plan for Regulation
March 11 (Bloomberg) — Charles Calomiris, a professor at Columbia University, talks with Bloomberg’s Tom Keene about U.S. housing, the banking industry and Federal Reserve Chairman Ben S. Bernanke’s “different tack” on financial market regulatory changes.
The comments are made 27 minutes into the interview. URL to the podcast is http://media.bloomberg.com/bb/avfile/Economics/On_Economy/v2rHC6K9VSwk.mp3
trader,
your posting is absolutely fantastic and well worth my daily read… encourage you to keep up the excellent work even when the blogging gets onerous (having attempted to run my own site I know the feeling)
best wishes,
Awake
Great post! Just to make sure whether I got it right regarding this “So, if you think that the dollar will weaken by 50% relative to the Euro in the case of a US default then the fair USD-denominated US CDS spread should trade around 50bps.”
In order to find that with approximately 50% depreciation of USD against EUR do you do this?: 10 million EUR protection means 18 million USD protection effectively (with exchange rate expeted to be EURUSD 1,8) . With the current exchange rate : 18 milion * CDS Spread in USD / EURUSD exchange rate (1,3) = 100 000 euros
I find the CDS spread in USD to be about 72.
Is there anything wrong with my calculation, if yes could you please clarify it?
Many thanks
That’s basically right. You have to be careful though since there are two things going into figuring out the “equivalent” USD CDS Spread. The first is the drift of the two currencies relative to each other (based on level of rates, correlations, vols) and the second component is the “jump” parameter which is the instantaneous devaluation of the local currency upon default. You really need to take both into account to come up with a “theoretical” value of the quanto. In the real world, of course, traders will tend to come up with the quanto based on where existing markets are trading (ie eastern european quantos, latin american quantos) rather than blindly sticking things into a model.
[...] More here. [...]
Thank you. I’ve been waiting for this post for months. Unfortunately, I’m left more than a bit nonplussed, even after several reads.
First, and most importantly, I’m disturbed by the statement that CDS don’t trade on fundamentals. Your advice to think of it as a spread play rather than a default play is a distinction without a difference to me. I don’t believe my confusion is linked to a reliance on my part on the insurance analogy.
Second, I’m not convinced the correct apples-to-apples comparison is a hypothetical USD-denominated US sovereign CDS. To my mind, the cleanest measure of a sovereign CDS spread would be one denominated in a currency wholly unrelated to (i.e. uncorrelated with) the underlying ccy. Absent a counterparty capable of paying in Martian Dollars, such cleanliness is unachievable. But surely EUR spreads are cleaner than USD spreads for US Treasury obligations *precisely because* the wrong-way risk is mitigated.
The only explanations I’ve read that make any sense to me are, in no particular order: (1) counterparty risk: the entities purchasing protection on US Treasuries are more likely to default than the entities selling protection; (2) the “headline” spreads are unreliable due to lack of liquidity and a critical mass of dealers; and (3) US Treasury default is not impossible, or even unprecedented. Obviously the latter provides cold comfort.
In Bob Rubin’s biography he discusses an episode in the 1990s where Newt Gingrich tried to get the House to vote against authorizing payment of interest on treasuries in order to give the Republicans more leverage in some political power struggle. I think this clearly would have been a credit event, which might have had some value from the cheapest-to-deliver option. Seems to me that the possibility of a US credit event is non-trivial, mainly due to the possibility that something like this happens again in the future.
This is a great blog btw
My fault for not making this clear. I do in fact think that CDS trade on “fundamentals”, which reflect thinks like credit quality, risk premia, liquidity, volatility, etc. However, I don’t think CDS trade because people earnestly expect to witness a default by the reference entity. So, the default vs. spread difference I ‘m talking about is simply that if I buy protection on GE today, 99 times out of a 100 it’s because i think GE spread will WIDEN not that GE will DEFAULT. Clearly, the widening that I expect will be due to higher likelihood of default however a small increase in the likelihood of default is not the same as an expectation of default. So, it is my contention that people trade CDS based on views on changing expectation of default not views of an actual default.
You touch on an important point here. I would agree with you that denominating US protection in EUR is cleaner but that’s only the case if you are a EUR investor (ie you see your p/l in eur). If you are a US based investor your P/L is reported in USD which means that your EUR protection on US does still carries eur/usd fx risk. Here you would need to actively manage the fx risk if you want to separate the credit and fx risks.
Not sure I understand this one. I would argue that default either by the treasury or by counterparties doesn’t much enter into the picture of trading US CDS, but may be you can clarify the point.
It would seem that the most uncorrelated “currency” is gold.
It would be interesting to find out if a very large holder of gold had ever written or attempted to provide payment for a US credit event in gold, and if so, what that gold owner charged or wanted to charge.
ATC/Admin:
To clarify my point about counterparty risk…
Premise: Counterparty risk is reflected in the “headline” CDS spreads we see quoted on US Treasury as ref entity.
As you mentioned in the AIG post, counterparty risk is bilateral. That is, both the buyer of protection and the seller of protection are exposed to the credit risk of the other party. If the spreads have tightened and the buyer defaults, the seller is exposed. Likewise (and perhaps more intuitively to some), if spreads have widened and the seller defaults, the buyer is exposed. These risks necessarily counteract each-other when determining the fair spread between counterparties. Furthermore, other factors (collateral, netting, asymetric exposure curves, shape of credit curves, etc.) can mitigate/alter the extent to which one side of the counterparty risk coin offsets the other. Nevertheless, all else equal, one would expect counterparty risk to serve to decrease fair market CDS spreads when the seller is more risky than the buyer, and vice versa. Hence, if there is a selection bias among those purchasing EUR-denominated UST credit protection against such that those protection buyers tend to have higher spreads than the sellers from whom they buy protection, then we would expect to see higher-than-otherwise CDS spreads.
Personally, I have no insight into who is buying this protection, from whom, and in what volume. But I wouldn’t be surprised if it was China, from various European moneycenter banks de-facto backed by their respective Governments, in sparse volumes. If true, this might explain (for me, anyway) part of the reason for seemingly high spreads.
Oh, and btw, I changed my mind about “cleanliness” of CDS spreads. The presence of any significant non-zero correlation between the purchasing power of USD and EUR renders the EUR-denominated spreads just as “unclean” (if not moreso) than a hypothetical USD-denominated swap. That is, the hairiness of the quanto is no better than the hairiness of the wrong-way CDS.
DoctoRx: You may be right that gold-denominated CDS might be cleaner yet. My boss and I often joke that the UST CDS ought to be denominated in portfolios of refined gasoline, bullets, and spiked shoulderpads (see “Road Warrior” c.1985).
I thought the recent price hike in UST CDS was due to old fashioned convergence arbitrage. In which the UST CDS is bought as a save way to short UST. In save I mean knowing beforehand what the cost will be. Recent market turmoil meant huge flights to UST. Which would cause a MTM short squeeze, this is off course circumvented if you shorted UST via a CDS.
Does this view have any merit or is there nobody gutsy/liquid enough to put on a convergence arbitrage trade?
The voice of reason.
Please keep up the good, and important, work.
[...] A Credit Trader points out that uses the price of CDS or their spread across countries doesn’t necessarily tell you something about underlying default risk: [O]ne shouldn’t look at CDS as a “default” trade. Though their pricing is clearly driven by the likelihood of default and the payout upon default, I can tell you that 99% of people buying CDS do not believe that the entity upon which they are buying protection will actually default. In this, they are similar to investors in stocks. People buy and sell stocks because they think the stock in question will increase or decrease in price. Same goes for CDS. [...]
[...] the hullaballoo about U.S. sovereign CDSs clearing 100bps, credit-default swaps are not a default trade. “99% of people buying CDS do not believe that the entity upon which they are buying [...]
My guess is you would just trade something like a CMT10 swap rather than shorting bonds outright. Liquidity in CDS is not there for people to seriously consider doing this trade I think plus you are wearing just a massive basis risk. Buying CDS vs. shorting bonds; these trades are not driven by the same risks.
I would be shocked if it was China. First the CDS liquidity does not even begin to approach the $1.7trn of bonds that China has, so this is a non-starter right there. The other point is that buying US CDS is the same as the Chinese selling dollars in the spot market to hedge their exposure. The market would know about this in an instant, the dollar would plummet and the Chinese would take a massive loss on the portfolio. The last thing China wants to do is to rile the markets right now.
this is pretty scary. my guess is just like in the debt ceiling raises, the Congress would just make some noise and then fall in. Although given how much people hate CDS traders, they will probably try to stick it to them just for fun
Is it not the CDS on “never actually going to fail” entities that the US taxpayer is now being forced to pony up and honour?
Seems to me that these were not just trading vehicles after all, BWDIK?
The notion that it’s the “spread” rather than the “default” that is being traded led me to a more (IMO) sensible analogy than the “Titanic”-type explanation:
CDS and CDOs are simply 21st century counterfeiting schemes.
By that, I don’t mean the typical printing press method of counterfeiting sovereign currency. Instead it is of the “market” variety: counterfeit baseball cards, counterfeit Picassos, counterfeit truffles, counterfeit stock certificates…obviously, the physical nature of those counterfeiting “market” schemes limits their reach. And, the individuals become conspicuous because, well, they are individuals. But the larger the counterfeiter, the larger the nominal value of the counterfeit scheme.
Let’s use the baseball card analogy to illustrate.
An authentic “Honus Wagner” baseball card is worth thousands and thousands of dollars to certain collectors. But only to collectors…no intrinsic value. Facsimile cards have been issued, and they are worth mere dollars, even though these facsimiles mimic every absolute quality of the original, down to the paper, except, they are NOT “original”.
So what if “certain collectors” got together, and agreed to issue “new, but original Honus Wagner” trading cards, based on the -idea- that if the original card is worth thousands, why, then, these new “originals” are also worth thousands…maybe tens of thousands! If the “certain collectors” all agree, then the trading may proceed, and prices rise and fall among the traders (and the traders ONLY), yet remain in the tens of thousands, so long as they all agreed for the reasons behind the pricing….”original cards of Honus Wagner” are valuable, simply because they (1) use Honus Wagner (2) are original.
The difficulty arises when mixing the “created value” of these “original cards”, denominated in dollars, into the widespread financial system of dollars. If you own a grocery store, and you add to your balance sheet your “collection of original Honus Wagner baseball cards” as part of your asset valuation, you have simply committed a “counterfeiting” act. I have invested in your grocery store, and I come by one day, and the shelves are bare…”Where are the groceries??” “The heck with groceries, business has never been better! My net worth is now $900,000!! I have a huge amount of “original Honus Wagner cards”. That is where I directed the money from the grocery business. Your investment of $30,000 is now worth $450,000!!”
“Reach in your pocket and flip me a $20, as a “bonus”!!”
Once you start “creating value” by agreeing among a small group, what constitutes “value” of an entity normally reserved for sovereignty issue with NO INVOLVEMENT of sovereignty entities, you are creating a de facto counterfeiting scheme. Counterfeiting baseball cards is illegal, and for good reason: it is illegal to debase a sovereign currency by whatever avenue chosen. If no one expects “default” then the reason for issuing a CDO is not based on a real “value”. Just as the newly-issued “original Honus Wagner baseball cards” traded on the agreed-upon notion that “Honus Wagner=value” and “originality=value”….”the probability of a large company (or bond) to default =value”….well, defaults do occur in the real world, but does “default” truly have the dollar value assigned to it in a CDO?
Only among the traders. And they should never have been allowed to unilaterally assign value to a constructed value, a value concocted within their “baseball trading card club”. That is the very definition of counterfeiting.
Bergquist, this is an interesting analogy. I would just add that sovereign default risk is not entirely constructed as sovereigns have defauled /restructured debt in the past.
Sovereignty is a 19th-century legal notion that became sacrosanct in the 20th century by the German conquest of so many little countries (Japanese imperialism as well pushed the noble concept). The United Nations is the lynch-pin of the sanctity of sovereignty. But can the “sovereign” effects of the USA be equated to Zimbabwe, Iceland, Moldovna? Can the idea of “failed states” (i.e. lacking sovereignty) be applied to nations that overprint money, or in other ways, abandon the basic practices of sovereignty? Sure, sovereign “states” default (Iceland) even if they were once well-functioning entities. I should have thought through my analogy, and used the term “Monetary Authority” because certain “sovereign states” abandon their monetary authority (Germany in the 1920s, Zimbabwe now, Brazil in the past) by collecting tax revenue via the printing press, and creating “de jure” and “de facto” money. Those that abandon, or lose (Iceland) monetary authority are simply transformed to unwitting promoters of the 21st century counterfeit schemes, by providing the physical structure of the “clubhouse” for the “trading club”.
Recall Gresham’s Law, that bad money drives out good money. When the Fed effectively lowered interest rates to zero, 2001-2004, what money was there to “drive out” good money? CDOs and CDSs, SIVs and other “counterfeit dollars”.
We are soon to reach the second effect of Gresham’s Law in the credit card market. When credit is unobtainable, then credit scores don’t matter. When credit scores don’t matter, then paying on unsecured debt is -the same- as NOT paying on unsecured debt. So, each month, more and more people are making payments with “bad money” (i.e., a payment of zero dollars) and hoarding the “good money” (actual US dollars).
[...] to zero in the worst case scenario) and it isn’t the prospect of a debt default (see here for an interesting discussion on why CDS spreads can expand). It’s the reinsurance [...]
Admin,
how about a dual currency board or some weird form of currency controls? Assume f.e. the US splits its currency in an goods $ and a financial $ as many countries did after the second world war. How would a CDS reference in such a scenario?
THX
I would imagine that since sovereign CDS trades very much like a fear guage (more correlated to libor/ois rather than sovereign risk is my bet) this cannot help the market confidence. I think actual levels of sovereign spreads are sufficiently divorced from default risk that the majority of the price action of sovereign CDS is caused by investor confidence in the CB and the gov’t. Adopting any currency controls will cause the CDS to explode I think regardless of any fundamental benefit such controls will bring.
[...] Fair Loan Rate! created an interesting post today on US CDS above 100bps: itâ [...]
Who passed the Geithner plan?…
Is that it, then? You know, the “Public Private Investor Partnership” that the Treasury Secretary introduced on Monday. Are we doing that?
The plan involves the Treasury, FDIC, and Federal Reserve putting hundreds of billions, perhaps more……
can someone please send me the link or a JPEG for the latest chart on the 10 year US Govt CDS Spreads, would greatly appreciate, thanks
Top Tips: Looking for Critical Illness Insurance Cover…
The following tips might seem like the obvious thing to do but you’d be surprised at the number of people calling us that haven’t considered any of them.
Always get quotes and compare cover from more than one provider
Always check which co…
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