US Default Risk Soaring

Shorting subprime? That was a good idea. Or shorting agencies, or any other credit product, for that matter. But shorting US Treasuries in July? That, surely, would have been pretty disastrous.

Unless, that is, you went short not directly, but rather by buying credit protection on them. Yes, there is such a thing as a CDS on US Treasury bonds. It cost 1.6 basis points back in July; it costs 16 basis points today. Quite a nice little earner!

A correspondent asks me how such a thing is possible:

I'm trying to imagine a scenario where a Treasury bond defaults, but a CDS contract promising payments in the event of that default is still worth something. ie, any scenario where the CDS seller would have to make a payment would have been preceded by the probable collapse of our financial system, since Treasuries are used as risk-free collateral by every bank on earth. The currency that the CDS is written in would probably be worthless, and one doubts that even the transmission mechanism to send the CDS payment would survive a Treasury default, since payments are made through banks which would have collapsed in the case of the United States defaulting on its sovereign debt.

In fact, it's not quite as bad as all that. Indeed, the US government came reasonably close to an event of default as recently as 1996, when the Republican party shut down the government during budget negotiations with the Clinton White House. There was a real fear, at the time, that the government would be forced to default on some upcoming bond payments, and that such a default - although it would surely have been cured pretty quickly - could cost the US its triple-A credit rating. That would have been pretty gnarly, but I don't think that any banks would have collapsed as a result.

All the same, the fact that people are buying credit protection on Treasury bonds at non-negligible prices does go to show how crazy the markets are right now. After all, 16bp is where the iTraxx Japan index of Japanese corporate CDSs stood as recently as June; it's now the cost of insuring risk-free debt.

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