Insurers view investing in US Government debt to be just as risky as investing in the debt of a large US corporation. Here is a chart of the price of a Credit Default Swap on 5-Year US Government Debt:
Before discussing the chart, let’s examine what the price of the CDS means. A credit default swap is properly thought of as an insurance contract. A company selling or writing a credit default swap is akin to writing an insurance contract to a buyer that guarantees payment to the buyer in the event that the bond it is referencing defaults. What does it mean for a bond to default? It means that a payment is late, or a payment comes in at less than 100 cents on the dollar. How are insurance contracts typically priced? The price reflects the expected value of the losses over the life of the contract. For example, if I crash my car and the cost of replacing that car is $20,000, and the chance that I total my car is 5% in any given year, then the insurance premium (“price”) ignoring transactions costs would be $1,000 per year. If a company sells me insurance at this price, it would expect to break even doing so – because over time it would be collecting exactly the amount of premiums as it expects to pay out in losses.
The prices of CDS contracts are analagous. The price of the CDS captures the expected value of the losses over the life of the contract. The prices are typically quoted in “basis points.” A basis point is just 1/100 of a percentage point. So, if the price of a CDS were 100 basis points, that is the same as saying it is 1 percent. 1 percent of what? Of the value of the bond being insured. The bonds referenced are typically in $10 million blocks. Thus, if we see a price for a CDS on a bond priced at 100 basis points over 5 years, it means that the expected value of the losses on insuring those bonds is $100,000 over the next 5 years.
Now, onto the chart. It shows the prices for CDS on 5-Year US Government debt from the end of 2007 until the middle of March. It is remarkable that there is even a market for this! A positive price for a CDS means that investors believe there is some risk in holding the bonds. That seems to be unheard of in modern US history. Notice that the price on the US contract was less than 10 basis points at the end of 2007 and now has more than quadrupled to 43 basis points in 2011. This means in some sense that investing in government debt is over 4 times riskier today than it was a few years ago.
For comparison purposes, the price of a CDS on the 5-year bonds of Proctor and Gamble …. 43 basis points. That’s right, investing in the bonds of a multinational consumer products firm is no riskier than investing in the bonds of the world’s richest and possibly most stable government. The beauty of the CDS market is that we can see what happens when people put their money where their mouth is, as opposed to writing OpEds or talking their heads off on CNN or Fox or wherever. When they have their own money on the line, we see that there is a belief that the government is at a considerably higher risk of defaulting today than they were one year ago, two years ago and fours years ago.
At the time of this writing, Germany’s debt was being insured for 46 basis points. Italy: 157 bps. Portugal: 501bps. Greece: 963 bps. This is no joke.
I question the wisdom of people buying CDS on US government debt. Buy a CDS from whom? If the US federal government actually defaults (as opposed to inflating their way to reduced debt), can we actually rely on the counter-party making good on my CDS? Could AIG have made good without US government assistance, the same US government that is now hypothetically defaulting?
[…] by an economic professor at the University of Rochester by the name of Michael Rizzo (see “No Joke”). I have previously suggested in class that the traditional proxy for the riskless […]
[…] by an economic professor at the University of Rochester by the name of Michael Rizzo (see “No Joke”). I have previously suggested in class that the traditional proxy for the riskless […]
[…] by an economic professor at the University of Rochester by the name of Michael Rizzo (see “No Joke”). I have previously suggested in class that the traditional proxy for the riskless […]
Great observations, Wintercow.
My prediction is that the US government will not default on its debt, and why would it, since its debt is denominated in dollars. The Federal Reserve just created a boatload (super-tanker) to provide liquidity for Tim Geithner’s buds.
My recommendation is to shepherd your cash, because higher interest rates are coming. I am not alone in that estimation. Soon, those of Tim’s generation will read a history book or two, which Wintercow, of Tim’s generation, has already read.
In my humble opinion, I would not buy for my own account long-term Treasurys yielding the paltry amount they fetch today. But Ben Bernanke is not buying for himself, is he?
I know history does not repeat itself exactly. This time we had additional pernicious influences on a grand scale with Freddie Mac and Fannie Mae. But these are not reruns of the Great Depression — they are reruns of Jimmy Carter.
By the way, Don Trump should stick to real estate management, and stay away from the protectionist bandwagon. However reprehensible the Chicoms are, they are stuck with depreciating dollars, and even they know they are being screwed by our government big time.
the power of prices….
amazing