You are hereNewsweek: The World's Strangest Financial Instrument

Newsweek: The World's Strangest Financial Instrument

Why does anyone buy insurance policies that pay off only if the U.S. goes bankrupt?

March 17, 2011- Does it make sense to buy insurance against, say, a nuclear attack on Washington—if all the insurance providers' headquarters are inside the Beltway? Of course not. So why do investors buy insurance on U.S. government debt?

As many of us learned painfully during the economic meltdown, credit-default swaps are a form of insurance on financial instruments. They're contracts that pay off in the event that an entity fails to make good on its debt. You could, for example, pay a $2 premium to insure $100 in debt of, say, Lehman Bros. If Lehman goes Chapter 11, the party that sold the insurance pays $100 (or the difference between $100 and the amount Lehman can actually pay its creditors). Selling credit-default swaps is a fantastic business so long as the insured instruments or companies don't fail. That's what got AIG into so much trouble. It sold cheap protection on huge amounts of subprime mortgage bonds and collateralized debt obligations but never put money aside to make good on potential claims—leaving taxpayers on the hook to pay them off.

This brings us to the odd business of credit-default swaps on countries. In the sovereign credit-default swap market, investors can purchase (and trade) protection against the default of debt issued by governments, such as, say, Greece. In the wake of Greece's recent woes, there have been accusations that trading in CDS helped aggravate the crisis. Of course, Greece, it turns out, was never in real danger of defaulting on its debt—the notion that Europe's financial powers would have stood by while a euro-using country simply reneged on government debt was far-fetched.

So why bother with credit-default swaps on nations? CDS are a way of hedging existing positions: The value of CDS rise when the value of the bonds they insure fall. They can also be a cheap way of expressing a pessimistic view on countries' financial prospects without going to the trouble of selling short the bonds issued by the national government. Many people buying CDS for a country don't expect to collect the insurance, they expect to sell the insurance policy to somebody else. For investors, sovereign default swaps are not buy-and-hold insurance policies. They are a form of casino chip.

But in the long run, CDS only make sense as an asset class if they pay out in the event of default. This is why it's so curious that there is a market—albeit a small one—for credit default swaps on U.S. government debt. After all, if the U.S. government were to default, who would be able to pay the claims?

According to the Bureau of Public Debt, there is $8.15 trillion in U.S. government debt owned by the public. In addition, now that the United States has taken control of the failed mortgage giants Fannie Mae and Freddie Mac, the government is formally standing behind the debts of those two entities, which surpass $5 trillion. Now, let's imagine a world in which the U.S. government, lacking the will to tax or cut spending, can't scrape up the cash to stay current on interest payments and can't roll over debt as it matures. That would trigger a huge decline in the value of treasuries and mortgage-backed securities. The balance sheet of every U.S. financial institution—JPMorgan, Goldman, Citi, your neighborhood bank, the Federal Reserve, money-market funds—would be decimated. There wouldn't be a single solvent bank, insurer, or company in the United States. The large multinational banks, which have significant U.S. operations and plenty of this stuff on their books, would likewise be wiped out. Oh, and foreign holders of U.S. debt—see this list topped by China and Japan—would be toast, too.



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