….the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?
No, they are not crazy, the contracts will be honoured: 100%, guaranteed, for a simple reason, most sovereign CDS are packaged in fully funded credit derivatives first-to-default credit linked notes, therefore the protection buyer gets the cash upfront and is not exposed to the protection seller credit risk.
Interesting theory
Yes Sir, you are missing the point ;-)
For the sake of simplicity, end-users means people with a net position, unhedged, while dealers means people with positions either hedged or matched.
Case1: retail investors buy the CLN, that means they (retail) sold protection and it is funded, the bank bought protection and it has bonds in portfolio so the bank is “hedged” like in a basis trade, (which means it is not perfectly hedged but that’s a story for another day).
Case2: retail investors buy the CLN, that means they sold protection and it is funded, the bank bought protection and doesn’t hold bonds so it is going to sell protection to some other end-user for ex a hedge fund, the bank position is long protection form the CLN, retail is short (funded) protection via the CLN, the bank is also short protection with some other end user, the hedge fund in this case that is obviously long protection, there is no unfunded sold protection anywhere, as the bank is hedged or matched.
I’m not sure I get the distinction between “end-users” and dealers. Imagine for some weird reason there is $500bn of retail issuance of US CLNs (this would never happen – on average a retail CLN is 10-100k and these clients like a yield pickup of 5%+ which you would never get with any sovereign CDS outside of Iceland and a couple of LatAm names). Then, let’s say this one dealer that has $500bn of US CDS business (let’s ignore also the fact that liquidity would never support this kind of issuance) sells $500bn of US CDS protection in the street to synthetically create this CLN issuance. Let’s pretend there’s only one other dealer on the other side of the trade. Then, if and when US CDS widens to oh 1000bps, the dealer that sold US CDS protection is basically bust. My point is that some dealer somewhere has to sell unfunded CDS protection in that size. There’s no getting around this issue. May be I’m missing your point.
As for most CDSs, the bulk of gross positions is held by dealers and nets out to zero or close enough to zero, what matters for systemic risk is whether the end-users protection sellers are funded or not, AIG was writing unfunded and “retail” is writing sovereign on a funded basis. I don’t agree that there has to be unfunded US CDS risk, you can hedge with another CDS but you are then long+short=0 or you can hedge with a basis trade which is the way to go since the basis is negative against certain deliverables.
Interesting theory…the issue here is that by saying that all US CDS risk is funded only pushes the unfunded risk up the chain. Say an investor comes to me with $100 and says I want a USD-denominated CLN linked to US CDS risk. What do I do? I got to the market and hedge my CLN issuance by receiving $ rates and selling US CDS. Otherwise I am running naked risk. So, at the end of the day there has to be unfunded US CDS risk one way or another.
More here:
http://www.acredittrader.com/?p=81
as always thanks a lot for the blog posts..its amazing.
i guess they are not fools also because even if USA does not default, the fear or increased lack of confidence will increase the value of the CDS which is basically a way to bet on fear.
Now where did i read this the last time?
troy:
we are in agreement, for $1 of notional that lands in a structure there is a ? multiple of that traded banks to banks, I am well aware that sov clns aren’t big relative to the clns market, what i was trying to say probably not very well, is that the net-net customer flow ends up in clns or other fully funded structures, unlike the aigfp cds book that was backed by hot air i.e., unfunded.
Yes there is a cln market with sov cds exposure but very small compared to the cln market overall. As far as sov cds, most voluem is single name traded by banks to banks.
I don’t think many are holding these out as literal insurance on US default, rather as a “convenient way” to short a bond thought to be under pressure ala Soros’ view in his January FT article, The game changer:
“The second step is to understand credit default swaps and to recognise that the CDS market offers a convenient way of shorting bonds. In that market the asymmetry in risk/reward works in the opposite way to stocks. Going short on bonds by buying a CDS contract carries limited risk but unlimited profit potential.”
So, my guess is that ppl are trading the CDS not holding to maturity. Krugman’s being unusually narrow-minded in his blog piece.
Love ya work jck.
troy:
can’t quote the source. suffice to say that in europe and the gulf there are buckets loads of small issues (10-25 million) clns and emtns referencing sovereign baskets.
“the net position is held mostly by ftd-clns, i didn’t say the whole of the gross notional is ftd-clns.”
according to who? your misinformed, but your blog rocks.
moruobai:
thx.
I don’t think people buying that stuff expect the U.S. to default Argentina style, rather there is some scope for a technical default for ex. the debt ceiling will need to be increased and these negotiations have come down to the wire in the past, remember NO grace period for USA CDS, moreover there are technical factors that will keep on pushing the spread wider not just because of the increasing deficit but also the increase of deliverables that trade well above treasuries, for ex. bank bonds issued under the TLGF are deliverable against the CDS, nationalizing banks and restructuring these bonds could be a credit event.
Always great blog. Can someone explain the steps of the transaction? If I agree to buy CDS protection on a US Treasury, what transactions take place?
Thanks, Josh
jck:
Just wanted to say first off that I think this is maybe the best financial blog in the world, so thanks a lot for writing it.
However, I also really think you’ve got this post wrong. Krugman’s broader point is correct. If the US were to default, the world economy would be in such terrible shape that the only collateral I would have any confidence in is food. Certainly not Euros; or even gold.
troy:
the net position is held mostly by ftd-clns, i didn’t say the whole of the gross notional is ftd-clns.
barry:
USA CDS are quoted and settled in euros, there is no US trustee, or any US whatever involved here. You certainly don’t want to buy protection from a US entity.
they are just borrowing money, the seller of protection is exposed to counterparty risk, not the buyer as Paul K or Taleb seem to think.
“most sovereign CDS are packaged in fully funded credit derivatives first-to-default credit linked notes”
not at all
I believe that Krugman is correct. In credit linked note, I thought the notional was held by a trustee and only released in the event of a credit event. If the trustee is a US domiciled bank and there is a true default (as opposed to some technical late payment), there is a good chance that the trustee bank maybe prohibited from making that transfer
I was wondering about this after reading Krugman’s post. Are buyers of sovereign CDS essentially just borrowing money then? What effective interest rate are they paying for these funds? Is the seller of protection exposed to counterparty risk?
What, that doesn’t make sense. So I buy Protection on the US defaulting. And the counterparty gives me the Notional amount up front. Whats the point then he is taking my credit risk. If he places with a third part we are both taking his risk. Krugman is right. Its like buying insurance against the sinking of the Titanic from someone on the Titanic. A comment like that needs more explanatio to have any meaning.