Saturday, July 23, 2011

CDS for U.S. Treasuries

A lawyer for the International Swaps & Derivatives Association said the trigger for a U.S. debt default is unclear.  Organizations selling credit coverage via credit default swaps (CDS) do not have an operational definition of default. IFR reported:

"It’s not necessarily clear whether US CDS would trigger if they did not manage to resolve the debt ceiling negotiations successfully and then subsequently failed to make coupon payments on Treasuries,” said David Geen, general counsel at ISDA. “Usually it would be a clear failure-to-pay credit event if payments were not made by the end of the grace period. The problem is that there does not appear to be clarity about grace periods on Treasuries and we are currently researching this issue.”

“In order for there to be a credit event there has to be publicly available information that says this payment was due on this day and it wasn’t made, and that may not be that easy to demonstrate,” he added.
 CDS prices on U.S. Treasuries have an interesting history:  Summer 2008 showed:

The cost to insure Treasury debt with credit default swaps jumped to 16.5 basis points, or $16,500 per year for five years to insure $10 million in debt, from 8 basis points on Thursday, an analyst said.

Credit default swaps are used to buy protection against the likelihood of a borrower defaulting on its debt and to speculate on an issuer's credit quality. Protection costs rise when people become more concerned about an issuer's credit quality.
February 2010 found:

In the credit default swap market, the five-year price to insure against a U.S. Treasury default was last about 57 basis points late Friday after rising to 59.3 basis points earlier, a level not seen since April 2009.

This meant traders would pay roughly $57,000 per $10 million in Treasury exposure late Friday. It was also six times less than what it would cost to insure against Greek, Portguese and Spainish government debt

This week's rise in Treasury CDS prices implied traders have priced in about a 5 percent chance of a U.S. government default in the next five years, according to the credit data firm.
With a potential default less than two weeks away, CDS odds didn't increase.  A July 19 Reuters report stated:

Five-year protection costs, the most liquid contract, fell by 2 basis points to 54 basis points, or $54,000 per year for $10 million in debt, according to Markit.
Oddly, in a story comparing corporate debt to Treasuries WSJ pegged the odds of default much lower:

Credit-default swaps on the U.S. now imply a 0.75% cumulative chance of default over five years, according to Moody's Analytics. By comparison, such swaps imply a 0.7% cumulative chance of default for Microsoft over five years, 0.5% for Exxon and just 0.35% for Johnson & Johnson.
Wall Street must see little risk of default, otherwise CDS prices would be rising like 2008.  Also, investors would want coverage on a greater portion of Treasury debt. With $9.7 trillion in Treasuries outstanding, credit default swaps cover a mere $26.1 billion in gross notationals.  That's 0.27%.

Update 7-27-11: Reuters reported one-year U.S. CDS price rose to a record high 85 basis points, up 8 basis points on the day, while 5-year U.S. CDS increased 3 basis points at 62 basis points, a level not seen since February 2010, according to data firm Markit.  NPR put together a graph.  Note CDS prices are a fraction of levels seen after Lehman's implosion