Derivatives: Why Debt Ceiling Talk is Ridiculous

by JT McGee

Credit default swaps demand the debt ceiling be raised.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:

  1. To satisfy mathematical models and assumptions.
  2. Because they’re a popular novelty, much like the VIX index.
  3. 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

{ 10 comments… read them below or add one }

Jeff Reed July 12, 2011 at 09:07

JT,
I agree that the deal will get done. However the situation could get quite messy in the coming
weeks if Obama’s and Boehner’s haggling causes it falls apart. Here are a few things we need keep in mind:

1. There is no chance of a Treasury default on principal or interest, in my view. This is about willingness to pay — not ability to pay. Whether it comes down to a reliance on the 14th Amendment or on some accounting gimmick (such as the ones that have already been employed), no Treasury Secretary is going to allow the US to default on his/her watch.

2. I believe the threat of a missed social security payment will help lead to a compromise by August 2 that will entail either: a) a $2.5 +/- trillion hike in the debt ceiling that is sufficient to carry the government through until after the 2012 election or b) some sort of short-term extension.

3. Depending on the timing and the specific language included in any short-term extension, there is a chance that the Treasury auction calendar could be disrupted. (More bad headlines to scare regukar investors?)

4. A debt ceiling hike is not a done deal until it passes both Houses of Congress. This is a fairly unusual situation. Just because the Congressional leadership and the White House strike a compromise, it doesn’t mean that it is guaranteed to be supported by the rank and file. Remember TARP! (I still have the bruises)

5. Debt prioritization is not a realistic option. It is being advocated by people who simply do not understand Treasury cash flows. While it is true that the government takes in a good deal more in receipts than it pays out in interest on the debt over the course of a full year, on certain days the government takes in much less than it pays out. For example, the Treasury has an interest payment of about $30 billion due on August 15. On that day, they will take in about $15 billion in tax receipts, so they won’t even have enough to make the interest payment alone. Are the proponents of prioritization suggesting that the Treasury should withhold all of the $22 billion social security payment due on August 3, so they can cover a debt service interest payment that is due a couple of weeks later? If so, what is the legal basis for Treasury to do this?

Serious deficit reduction will require both tax increases and entitlement reform. Ouch! I can’t believe I uttered such an oath. Unfortunately, you can’t achieve a sustainable budget trajectory in the US by merely capping nondefense discretionary spending, reducing agricultural subsidies, and requiring federal workers to contribute more to their pension plans. At present, tax receipts are about 15% of GDP — the lowest in more than 70 years.

This is the point in our history as a nation we need a stong leader not a suave politician at the helm. Pardon me while I step off my soapbox.

Reply

JT July 12, 2011 at 10:23

Jeff,

Feel free to hop on your soapbox any time here. This blog is a open-ended soapbox for use by me and readers. I enjoy the comments, as it tells me that someone is interested in the discussion, or at least informing themselves about the “going-ons” in whatever topic they respond to.

I’m going to reply by line item:

1) Agreed. There’s an interesting concept you brought up here. Interesting that the US Treasury is using accounting tricks that financial planners like yourself should recognize easily: changing the growth rate on retirement benefits to realize immediate earnings. I’m pretty sure Graham called this trick’s bluff way back in the 1950s.

2) From what I understand, a debt increase past 2012 is off the table. Republicans are aiming for about this time next year, Obama actually said sooner, which I’ll give him points for. You know, he really is looking pretty reasonable throughout all this, and I’ll give credit where credit is due–even if I think he’s George Bush II.

3) Treasury disruption is minute, I think, but interesting perspective. May throw off a few ETFs and institutionals.

4) Oh, TARP, that necessary program that picked winners and losers. I wonder why Goldman alum Hank Paulson bailed out GS but let other IBs go broke…err, no I don’t. Truthfully, I think the Tea Party is full of it. The Tea Party, in my view, is just like the anti-war left: gone when it really matters.

Let’s get real on this one: Republicans lie about tax hikes. You and I both know that refundable tax credits are not, in any way, lower taxes–they’re subsidies. Ending refundable tax credits (or non-refundable tax credits, for that matter) is not a tax hike; it is an end to a subsidy.

5) I don’t know much about this.

I’m not entirely sure that we would have to raise taxes to get it done, but since there’s so much that’s apparently “off the table,” then tax hikes are a likely necessity. You said non-defense, which may be indicative of your own leanings, or just a characterization of the current discussion, but defense absolutely has to be on the table for me.

You know, we could cut the Defense budget in half to erase 25% of the deficit, right now. Even if we were to do so, we’d still spend three times more than the next big Defense spender. We make up ~20% of world output, but 50% of Defense spending. Doesn’t make sense. Especially when you consider that spending a ton of money should earn you savings in the form of economies of scale.

My personal soapbox is we need growth!

Reforming the tax code would be a great start. Going through regulations one by one would be a great follow-up.

You know what really gets me angry, Jeff? It’s that we could reform the tax code ENTIRELY, and RAISE actual tax rates while still getting growth. That’s what really irks me. Republicans and Democrats should make a deal: complete tax code overhaul in exchange for slightly higher tax rates. So much time is wasted in this country on beating the tax code, which provides ZERO economic return on time/capital. But yet, thanks to the lovely soundbites that bring the electorate to the polls, tax reform will never happen.

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Krantcents July 12, 2011 at 16:26

I don’t think it is a question of if they raise the ceiling! What compromise will occur in order to raise it? Politics has become very messy and partisan lately. What cuts will be made to bring the Republicans along?

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JT McGee July 13, 2011 at 09:52

Hopefully some cuts to defense. Easiest place to cut.

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Hunter July 12, 2011 at 22:58

I don’t think it’s really even reasonable to act like they won’t raise the debt ceiling, I’m just interested in the compromise. We are the biggest debtor nation in the history of the world and I believe we need to get it under control soon. Anyways, good article.

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mickdonalds July 13, 2011 at 08:55

I honestly don’t understand the debt ceiling at all? If you don’t have the money then you should not be able to make transactions. Its seems like its such a simple concept and politics just clouds everything with bills and laws so they can satisfy their hidden agendas. I’m in the generation that’s going to have to deal with this BS when we all get older. This is why our generation is “terminally stoned on apathy.”

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JT McGee July 17, 2011 at 23:47

The great thing about the saying “our kids and grandkids will pay for this!” is that we’re the kids and grandkids. 😉 We’re already paying for it.

Anyway, I guess the concept behind a debt ceiling is that once in a blue moon the public debt gets brought up. It’s kind of like making a to-do list with a deadline so that even if you pass up the deadline you still realize how bad you’re failing. Without the debt ceiling, it would never be urgent to examine the debt, so for that purpose it does have some value, in my view, even if superficial.

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mickdonalds July 18, 2011 at 05:41

Thats madness! Lol I see your point though, without it… things could get ugly, because our countries leaders are like 3rd graders trying to run a functioning society. Me and my father were talking politics yesterday (whom I am forced to live with due to the economy and outrageous college tuiton) and it just seems like a huge game, now he’s even playing with social security and if it doesn’t go out on August 3rd, then they’ll be expecting an 18 year old college lass living off ramen noodles to support her 65 year old retired father aswell? …lol can you say anarchy?!

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Sean July 17, 2011 at 23:28

JT: If $40K will buy you $40 million in insurance on default, isn’t that a 10-1 ROI?

If everyone has the public good in mind, then of course there will be no default. If they’re protecting the well-being of the banks, we’re also fine.

But what if they -say Congressmen like Eric Cantor, who is invested in CDO’s against Treasuries, or the people who have bought and paid for those congressmen- are just interested in personal enrichment?

The assets of those banks would simply transfer to those private individuals, right?

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JT McGee July 17, 2011 at 23:44

$40,000 will buy you insurance on $10,000,000 of debt, which is .4%, or 250-1. To be honest, Eric Cantor probably couldn’t tell you what a CDS is. I’d put money on that. 😉

CDOs and CDS are entirely different things. A CDO is a collateralized debt instrument. Example: a package of mortgage debt. It’s a debt instrument, and it’s collateralized by the ownership of real property. A CDS is a credit default swap, which is an agreement by one party to pay for the failure to pay of another.

The funny thing about CDS on Treasuries is that they’ll never be paid out. There might exist trillions of dollars in CDS instruments, which would bankrupt most banks overnight, and cause a ripple effect through the derivatives market. If CDS instruments were triggered on US Treasuries, you wouldn’t get your $10 million payout. If you did, it’d be worthless, since either:

1) Aliens have destroyed earth.
2) The dollar is worthless.

Put it this way, Sean, owning a CDS against US Treasuries is a little like owning life insurance to protect yourself against death. On paper, a CDS removes whatever risk exists from US Treasuries, much like a life insurance contract removes whatever risk exists from death. At the end of the day, though, life insurance will not save your life, nor will it bring you back from the dead.

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