If you’ve turned on the news at any point in the last month you’d hear all about the debt ceiling discussion and how Republicans, especially Tea Party Republicans, aren’t interested in raising the debt ceiling. Usually, some pundit goes around a roundtable discussion to ask, “Will they do it? Will they raise the debt ceiling?”
Then you get a bunch of political nonsense that ignores everything finance.
Look, the debt ceiling will absolutely be raised. I can guarantee it with 100% certainty, and it all comes down to a simple product called “credit default swaps.”
Credit Default Swaps
Credit default swaps are bets that someone else won’t pay. Bought and sold between two firms, they’re essentially a guarantee that if borrower X defaults, the company that sold the CDS will make good on it. To buy credit default swaps on US Treasuries costs $40,000 for every $10 million in debt. Thus, you can insure $10 million of US Treasury debt for $40,000 a year.
And I bet there are billions, if not trillions, of CDS products sold on US Treasuries for three reasons:
- To satisfy mathematical models and assumptions.
- Because they’re a popular novelty, much like the VIX index.
- Because banks know that they’ll never be paid out.
So just think about what would happen if the United States didn’t raise the debt ceiling. The US would earn a D rating from Standard and Poors, which would trigger the terms of CDS securities bought and sold between banks. Banks would have to come up with the money to pay off the other banks. They don’t have the money. If they did, we would have already paid off the US debt yesterday.
This is the very big difference between today and the 1990’s “Republican Revolution.” The derivatives market was not nearly as huge then as it is today, and it did not play a central role in politics until the first blow-up during the Asian Financial Crisis.
They will not let the US default, because if they did, every investment bank in this country and around the world would blow up immediately.
So there you have it. Turn off your TV; the people who report the news don’t want you to know that the debt ceiling will, with 100% certainty, be raised. Next time someone says that they don’t think the debt ceiling will be increased, tell them that they’re silly. Say, “You’re nuts, man. Just think about what that would do to the CDS market!”
Photo by: Kevin Dooley