Here is an interesting thread by James Lavish analyzing US Credit Default Swaps. James goes into detail about the risks of the current market and how it all might play out.
US CDS spreads have rocketed higher recently, suggesting an accelerating probability of default.
But why is this happening, and what exactly is the CDS market telling us?
Time for a Credit đ§”đ
đ§ Whatâs a CDS?
First things first, what exactly is a CDS, or Credit Default Swap?
If you subscribe to đ§ The Informationist, youâve heard me discuss CDSs before
If youâre new, though, or just need a refresher, this article is a great place to start: jameslavish.substack.com/p/credit-defauâŠ
TL;DR:
In short, you may have heard the term âCredit Default Swapâ in 2009, when the entire housing market imploded
The movie 'The Big Short' went into great detail about these and how a few gutsy traders made a killing on the housing market implosion
Still, a bunch of people left that theatre confused about CDSs
Letâs clear it up here.
First, a swap is just a contract between two parties (like a legal document) that agrees to swap one risk for another, simple as that.
Iâve traded thousands of swaps in my career, typically for foreign currency and hedging out unwanted risks
During the housing crisis, CDSs were used to swap the risk of a pool of mortgage debts defaulting on its payments
Owners of the mortgages could get insurance on the default of that debt by buying CDS âinsuranceâ
But unlike typical insurance, you donât have to actually own what you are insuring when you buy a CDS
You just buy the insurance from whoever is willing to sell it to you
Like buying a policy on your neighborsâ car. If he crashes it, you each get an insurance payout
That's Wall Street for you.
But remember, 'default' just means an event that triggers a payout
An entity doesn't have to go bankrupt for a CDS to be triggered
Here're examples from ISDA (International Swaps and Derivatives Association), the governing body that rules on the payouts for the CDS market:
Now, you may be asking, why would someone *sell* that?
Itâs all about probabilities and premiums
The seller is just betting that the bonds do not default, and they just collect the insurance premiums for a profit
OK, so, who buys these CDSs and can you buy some if you want?
đ© Who buys CDSs?
Investors buying CDSs are typically institutions: i.e., endowments, pensions funds, & big hedge funds
Some of them have massive positions in corporate bonds or US Treasuries
And they use CDS swaps to hedge out some of the risk that comes with these bonds
See, if an entity stops paying interest on their debt, they're in 'default'
At worst, the debt can become worthless
Though, in most cases, since debt sits higher on the cap table than equity, even in the event of bankruptcy, there will be some claim on the assets of the company
If you want to know more about how the capital structure of companies work, I wrote all about that, you can check it out for free here:
The second type of CDSs buyers are speculators, those using the spreads to make bets for or against an eventual default
I.e., if youâre a hedge fund and think Italy's chances of defaulting on their debt will rise, you can buy a CDS on Italian sovereign debt as a trade
As the risk of default rises, so does the price of the CDS, and vice versa
OK, this seems easy enough. As an individual investor, can I go out and buy some CDS insurance?
Well, since CDSs are priced and traded in $10mm contracts and you'd need an ISDA agreement, not likely
Also, Iâm simplifying things greatly here for everyone to grasp the basic concepts
In reality, when an investor goes to price out a CDS they want to buy, they use complicated probability and duration based models that look something like this:
đ”âđ« What are the spreads telling us?
Getting back to the whole point of all this, what exactly are the current CDS prices on US sovereign debt, in particular, telling us?
As we can see, the 1-year US CDS has skyrocketed this past month.
Whatâs more, is the US 1-year CDS is almost twice as expensive as the US 5-year CDS (the contract that is normally quoted for sovereign CDSs)
And US is the only developed country that has spiked recently
Check out the chart below and the little blue dotsâŠ
Over the last three months, the US CDS price has jumped higher, while the rest have essentially stayed the same, or gotten cheaper
Why?
Simple: on January 19th, the US Treasury announced that they had hit the debt ceiling
And unless Congress votes to raise that ceiling (yet again) the US *will* default on US Treasuries
In other words, we need to issue more debt to pay the old debt đ€Ą
Yep, kind of like âpaying your Visa bill with your Mastercardâ, as my friend @natbrunell (host of the Coin Stories podcast) likes to say.
Moving on...
So, how bad is it?
Letâs compare the last time we had a global financial near-death experience in 2011
If you recall, this is when Europe was in danger of melting down on the backside of Greece failing, and fears of worldwide bank contagion sent CDS spreads soaring
Yes, even worse than, and certainly exacerbated by, the memory of the Great Financial Crisis
Make no mistake, this latest move in CDS prices is a major statement by the markets
How major? Letâs put it in dollar terms
Remember that a CDS contract is $10 million in notional value, and so 66.855 bps (basis points) is an annual fee of $66,855
If your 1-year UST is yielding, say, 3.5%, youâre expecting to receive $350,000 in interest payments on $10 million of USTs that you own
But the risk that the US defaults on those payments is so high, that you are now willing to pay 19% of your income to protect yourself
Whoa.
Letâs dig in deeper
Using these figures along with a recovery rate, we can calculate the implied probability of a default
If you're wondering how we do this, I wrote an article all about bond ratings and CDS spreads that you can find here:
In short, using the spread premium along with an expected recovery, we can calculate the *implied* probability of an actual default, according to market prices
So, the CDS spread is telling you both the likelihood of a default and the expected recovery after that default
See, if there's a high expected probability of default but also a high recovery expected (amount bondholders will recover from the the defaulted bond), then the price of the CDS will be lower than if the expected recovery was low
And in English:
If you expect a default and donât expect much recovery from it, then youâll pay more for the insurance.
Using the .66855% US 1-year CDS spread and a standard 40% expected recovery, we can calculate the implied probability of default to be 1.12%
.66855 / (1.00 - .40) = 1.12%
The reality, though, is any default is likely technical and produces a timing issue only, and so the recovery is more like 99%, at worst, where the only loss is the time value of perhaps a few weeks
If we use a 99% recovery, then:
.66835 / (1.00 - .99) = 66.83%
So, the implied probability of default is then 67%
In other words, the UST CDS market has become little more than a short-term event-driven trade
The 5-year CDS is less expensive because traders donât want to lock in those payments for that long
The insurance is too high to justify paying 5 years for it, as the event is this year
Itâs a bit more complicated than that with duration calculations, etc., but thatâs the basic concept
So, the market is telling us that the probability the US defaults on its debt this year is extremely high and likely north of 50%
What remains to be seen is the actual fallout that would occur from such a default, even if the government plays it off as a *technicality*
Remember, the US has raised the debt limit *22 times* since 1997
So, with debt rising so rapidly, and the need to keep raising the ceiling more often, is it an anomaly?
Or will it keep happening? Especially with such a polarized Congress
After all, weâve had a technical default before: in 1979 Congress failed to raise the ceiling in time for the Treasury to mail out interest payments, and so the US Treasury *defaulted*
A technicality, maybe, and yes the Treasury paid all interest due, even with the delays
But the question is, when does the world take notice that the US has a desperate borrowing problem?
One that requires constant debasing of the US Dollar (making it worth less) in order to manage that Grand Canyon-sized debt hole?
These antics, the overspending, and any default will put a big, fat đŻ on our debt problem
Make no mistake, the world is watching.
And at some point, the world will just stop trusting that the US "always pays its debts"
And when they do, the Treasury will find it that much harder to just open another Mastercard to pay off all those Visas.
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