Over the next couple of months, the American public can expect an ever-louder din of opinions as we approach the next bogus political standoff — the debt ceiling hostage crisis.
Bogus? I’m not saying it isn’t a crisis when elected public servants threaten to sabotage our country and the world economy. It certainly is. That’s why it was such a shock when a routine (and silly) bookkeeping matter suddenly became a pressure point in 2011 after years and years of “clean” increases to the debt limit.
But what other country spends money and then pretends it’s optional whether to pay the bills for what they’ve already spent? That’s what makes planning to instigate a crisis over the debt ceiling so bogus.
Perhaps an even more bogus activity in coming weeks will be the unending flow of opinions from the chattering class about the likelihood of default. When is the last time you saw a pundit pay any penalty for offering entirely wrong predictions?
Rather than pay heed to uninformed people with nothing at stake, wouldn’t you rather hear what people who could win or lose billions of dollars might think? Their opinions matter to me. Moreover, you can watch their opinions change over time (and so can the pundits).
In the market, we set up watchlists so we can check them frequently when we care about the outcome. So here it is, pundits — a watchlist you can use to see what people who have real money riding on the outcome think of the possibility of default for the US and a couple of dozen other countries. Just scroll to the bottom of the list to see how US debt is viewed.
When the price of CDS (default insurance) goes up, the big money is betting the odds of default are going up.
Not to get too far down into the weeds, but you do have to know one other thing about this form of credit insurance. The insurance increases or decreases in value according to the expected loss after the default, as well. We call the price of bonds after a default the “salvage value.” The amount paid out is the face amount of the bond less the salvage value. In that way, CDS are a lot like car insurance. When your car is totaled, you have to give the insurance company the vehicle to get the check. During the early years of CDS, the buyers of credit insurance had to deliver the bonds to get the payoff. That worked until Dana Corp (the auto parts maker) went bankrupt, and much to everyone’s surprise, there was more credit insurance outstanding than there were bonds.
That’s when the rules changed. Now you get cash, but not the full face amount of the bonds you insured.
For example, if Treasury bonds miss an interest payment, that will trigger the payoff on the CDS. At that point, members of Congress, many of whom are millionaires, might wake up after their individual fortunes are crushed by the market, and decide to pay the bills. Most players in the bond market would expect that, so even the defaulted Treasury bonds will probably still trade at 90 cents on the dollar or higher.
That gives us a way of understanding the risk/reward of owning Treasury bonds and insuring them. Alternatively, it gives us a way to value the speculative value of betting against America’s credit.
In the first case, for those who use CDS as genuine insurance, the current yield of a 5-year Treasury Note is 0.83 percent. If the cost of insurance is 40 basis points (0.40 percent per year) for five years, then the net return on a credit-insured Treasury would be 0.43% per year.
It gets a lot more interesting if you look at the risk/reward for pure speculation. If the politicians fail to swerve when they play chicken with our national credit in a couple of months, a single three-month payment of ten basis points ($10,000 for $10 million face amount of CDS) could result in a million dollar payoff if the post-default price of those Treasury Notes drops to 90 cents on the dollar.
Pundits, place your bets. Or at least start watching how people with serious money are placing theirs.