The Ever Increasing Divergence Between Top-Down And Bottom-Up US Default Risk
An interesting observation that has developed over the past year is the ballooning spread between default risk for the US as a standalone entity (based on the country's CDS spread, which was last seen just inside 50 bps), and the cumulative risk of the constituent states that make up the US, once again based on their own standalone spreads, when adjusted by GDP contribution. This can be seen on the chart below. The computation takes the 16 states with quoted spreads from CMA (with the remaining states assigned the US spread itself), juxtaposed to the CDS of the US itself. As is evident, the spread continues to widen, and at last check was around 100 bps, just marginally tighter compared to the all time wides seen in June of 2010 when it hit over 120 bps. In retrospect this should not be all that surprising, as the general US CDS looks at the country as a whole, and gives benefit to the possible intervention that the Fed can (and does) do on a daily basis to prevent increasing default risk to the US as a whole: after all the US can always monetize its own debt, while California... can't. Nonetheless, if these spreads continue to diverge, we expect that convexity alone will start dragging the CDS of the US wider as well.
Courtesy of John Lohman