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Is Selling US CDS A Risk-Free Way To Short The Dollar?
There has been much conjecture on whether using CDS is an effective way to hedge against US default risk. Many theoreticians, especially those of the post-March lows variety, have sprung up and are speculating that buying Credit Default Swaps on the US is ultimately a futile and pointless endeavor. The main argument: a US default would likely mean that interconnected dealers won't recognize contracts on a US default event, as they themselves will be out of business. Even if they continued to exist, like cockroaches in a postapocalyptic world, the collateral which backs derivatives is mostly US Treasurys: the same obligations that would end up being massively impaired. Furthermore, even though US CDS try to isolate currency risk by being euro denominated, a somewhat gradual collapse into default would make the dollar lose its value, which would make premium payments in euros untenable for the protection buyer. Then again, regardless of theoretical considerations, in a world fleeing from any risk, it is precisely US CDS where everyone would be rushing to: just recall the 100bps US CDS wides reached in February.
But today, when the Fed has removed all systemic or idiosyncratic risk for who knows how much longer, do US CDS serve one very unique, indirect purpose? It stands to argument that size sellers of US CDS who receive euro-denominated periodic annuities and P&L equivalent variation margin, could be a major player in the US-Euro carry trade, as protection sellers could short dollars against their euro-based cashflows. Furthermore, being a seller in a derivative which, according to the above argument, one would be faced with a credit event only in theory, permits protection sellers to sell virtually limitless amounts of US protection, thus pulling an AIG. The difference is that not only would the protection seller be in need of a bailout, but so would the entire US, thus, grotesquely offsetting the risk and in essence neutralizing it.
And with the Roubinis of the world now screaming against the dollar-carry bandwagon, could the source of the actual currency imbalance be found in this arcane trade?
Some additional observations on the theoretical aspect of US protection transaction is the topic of Moody's most recently Weekly Credit Outlook piece. The rating agency's arguments do not differ much from those who believe risk is dead and buried.
The price of credit default swap (CDS) protection on the debt obligations of the U.S. government has been increasing in recent months, last week last reaching 34bps - the highest level since July. While interesting, the focus on the gyrations in the price of CDS on the U.S. seems to ignore this basic question – can one effectively hedge the risk of a U.S. “default” with credit default swaps? We think not.
Needless to say, the world in which the U.S. would default on its debt would be a world in crisis – a crisis, of which such an event would likely not be the beginning and almost certainly not the end. However, rather than explore the probability or the indirect consequences of a U.S. credit event, we focus on the mechanics of the CDS market coupled with some practical analysis.
The market for U.S. CDS is not especially large -- $11.1 billion in gross notional and $2.2 billion in net notional amounts. As is true of the OTC derivatives market in general, the major dealer-banks are the market-makers for U.S. CDS.
However, U.S.-based dealers generally do not participate. The market appreciates that buying credit protection on the U.S. from a U.S.-based bank is probably a futile endeavor for if the U.S. cannot meet its obligations, odds are – neither would the U.S.-domiciled dealers. As prices change driven by the market’s views of the probability of a credit event, the contracts are marked to market and the in-the-money party receives collateral against its unrealized P/L.
U.S. CDS contracts are also denominated in euros, making them quanto-like. If the U.S. were to experience a credit event, the dollar would very likely fall in value, and if the contract were settled in dollars, the protection buyer’s economics would be adversely affected. By denominating U.S. CDS contracts in euros, the market has sought to mitigate this risk.
Based on the above, it seems that the contracts and market practices have been engineered to eliminate the two most obvious risks – counterparty and currency. Still, we think that this is one of the cases where financial engineering is likely to be no match for practical reality.
Why? Firstly, an obvious point – major dealers are riskier credits than the U.S. government. The fact that they may put up collateral against their derivative obligations offers little relief because U.S. Treasuries (the very instruments on which the credit event would occur) represent a large portion of such collateral between counterparties.Secondly, given the interconnectedness among the major global dealers, the confidence-sensitive nature of their funding, and the very large exposures they all have to the U.S. market, we think that the “wrong-way” risk of buying protection on the U.S. from any major dealer is very high. In fact, the CDS market sends a similar signal as the correlation of CDS spreads – among the dealers and to the U.S. – is indeed quite high.
Finally, the currency risk is not fully mitigated either unless the credit event happens very abruptly. With the increase in the probability of a U.S. credit event, the dollar would likely fall making euro-denominated premium payments more expensive for a protection buyer with dollar-denominated P/L.
In summary, we do not think that CDS would be an effective economic hedge against a U.S. credit event. Of course, protection buyers might use U.S. CDS without actually expecting a credit event to occur. Uses might include “macro hedging” against rising credit spreads, “managing” the country risk limit, or betting on rising credit spreads. It is worth noting, however, that in this case the protection buyer is exposed to an unfavorable asymmetry of outcomes, which is unusual for CDS. While a credit event is not expected (or if it happens, the protection is worthless), the protection is guaranteed to expire worthless upon maturity.
While we disagree with Moody's that a US CDS contract is impractical, and have been fans of purchasing US CDS since it hit all time lows in the 20 bps range, the likelihood that portfolio managers do subscribe to this view is high. And taking the mechanics of the cash flow into consideration, and the perceived lack of virtually any obligation upon the occurrence of a possible outcome (which as Moody noted is a lack of any contractual responsibility to the protection buyer), the US CDS seller syndicate could easily be one of the key sources of dollar short funding: with sellers pocketing euros and immediately going to market and selling dollars.
The problem with this argument is that the size of this market is relatively tiny from an F/X perspective: there is only $11.1 billion in gross US CDS notional. Yet if the marginal seller is involved in a carry-type trade, a dollar-short unwind would probably have repercussions in the US CDS market. Not only would the dollar spike, but paradoxically US credit risk would probably widen dramatically. If that happens, the correlation desks' response would be to unwind matched pair trades, which could potentially have a cascading effect on a slew of interest rate products, not last of all US Treasuries.
Which is why any unwind at the heart of the prevalent risk trade now: the massive dollar carry, would impact virtually every investment product, quite possibly in self-referential feedback loops. If correct, it merely shows how much more the Fed has at stake in keeping the dollar depressed than merely getting mom and pop to buy Amazon at $130/share. Losing control of the carry trade will be the systemic equivalent of allowing Lehman's book to be marked-to-market: a potentially complete collapse in systemic confidence, which would have such far ranging implications as the $300 trillion interest rate derivative market. And when sudden volatility reaches this product universe which is 6 times bigger than world GDP, the events from last year will seem like a dress rehearsal.
A primer on sovereign defaults: when the reference entity is a sovereign, such as the U.S., a credit event includes the failure to pay interest or principal on Treasuries or government-guaranteed debt, a repudiation/moratorium of existing debt obligations, or a restructuring of the terms of obligations that disadvantages creditors.
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Selling US CDS should be deemed an act of Treason or defined as financial terrorism
+10 internets.
I have colleagues at work who feel like it is unamerican to talk about the country failing. I get cut off as ridiculous and disloyal when I start to address the idea we may not come out of this recession (I don't dare call it a depression to my chair who is in his 70s, because America always comes back and I am being absurd).
I hear you though, if I can buy insurance on your house, would I be motivated to burn it down?
Remember out debt at the end of the Clinton administration?
It took one Bush to get us here. It will take one anti-Bush to get us out, and Obama isn't it.
The homeland of greed and excess will not stay in a recession in perpetuity.
Well, may be pricing of any cds for soverign risk should be done differently than just having statistcal probabilities,since CBs can print unlimited amount of money. If I am to buy a cds,then I would require that a certain percentage of GDP to debt ration included and pricing done in relation to,say a comodities or gold index. This way,you take the CBs printing capabilities out of the equation. Say every percent of increase in the naton debt/gdp translates into a cash flow for the buyer. And any increase in gold or the commodtieis index in relation to that nation's currency,is also reflected in a cah flow for the cds buyer. Anybody care to come up with a theorotical mathematical model for that?
But today, when the Fed has removed all systemic or idiosyncratic risk for who knows how much longer, do US CDS serve one very unique, indirect purpose?
The important words are "for who knows how much longer".
Still, we think that this is one of the cases where financial engineering is likely to be no match for practical reality.
AIG was one of the cases where financial engineering was no match for practical reality. The sovereign money fairy had to come and drop money from helicopters. When a reserve currency sovereign defaults, exactly which money fairy would come? And if the money fairy doesn't come, what value do the CDS hold?
IMO the value of CDS have been revealed (absent a money fairy) to be limited to: a) pocketing cash and b) lying about one's balance sheet by claiming risks are hedged: "It's contained."
It's simply risk movement. They are going to continue to plow forward with full risk ahead and whoever will shoulder the burden can shoulder the burden.
Maybe this is when Atlas shrugs.
Psst. Finance is absurd. Pass it on.
All Paper Will Burn
But it's only apparent risk movement; do any of them truly believe the other party can perform? And if they don't, what about duty?
Well it's going to become pretty damn apparent that the bailout didn't work when the entire system crashes next year as we go from 20 plus percent unbanked. To 30 plus percent unbanked to 40 plus percent unbanked. To 8 percent check cashing fees to 10 percent check cashing fees to oh crap they just robbed us check cashing fees.
sensational work, TD. one of the very best pieces I've ever had the pleasure of reading here on ZH. and yes: price discovery is still a major no-no.
just scary good. thank you, Tyler, sir.
Talk about Socratic method. At least this help me put a little more detail on HOW the dollar carry may unwind. Financial engineering - creative finance - call it what you will. Itwas only meant to enrich the financiers and siphon money from the real economy. Don't tell me I does anything "real".
dumb... US can't default on UST... they have magic machine... to print
I agree ... The US will never default on its obligation even if it repays them for 1 cent on the dollar
...and that means every one holding dollar NOW would be worth 1 cent at THAT moment. How interesting...
I seem to missing a step but why does this hold:
"And taking the mechanics of the cash flow into consideration, and the perceived lack of virtually any obligation upon the occurrence of a possible outcome (which as Moody noted is a lack of any contractual responsibility to the protection buyer), the US CDS seller syndicate could easily be one of the key sources of dollar short funding: with sellers pocketing euros and immediately going to market and selling dollars."
Why are the US CDS sellers also selling dollars?
keep dreaming
So the best game in town, given QE is now permanent, must be selling US govt CDS and buying physical gold with the proceeds? Anyone got a chair for me - I could sell this shit all day long.
"have been fans of purchasing US CDS"
So TD, there still is that one more/last fool to unload to?
(in case of...)
nevertheless, many thanks for addressing the topic of the carry control vs JPs IRS lock on FEDs monetary – that in fact turns out as – fiscal (less the congress) policy ….
sell U.S. cds = sell protection on U.S., buy risk buy U.S. cds = buy protection on U.S., sell U.S. risk
Originally posted on December 3, 2008
Last sentence was my hypothesis as to why folks would buy CDS on Sam.
How do you devalue the scrip but not increase the yield on the sovereign debt? Monetize the long bond. How do you monetize the long bond whilst applying the proper narrative for the great unwashed? Lower mortgage rates. (Buy MBS and agencies and by lowering rates push folks to grab duration i.e buy long bonds, effectively monetizing the long bond.) Never mind that like the banks, when it comes to households, it is an insolvency issue not a liquidity issue. Creating zombie banks and zombie customers will create a rising tide that will raise no boats.
The psychology of such actions is the very negative feedback loop that the elites are trying to avoid ... why do anything now until you can get the new lower rate?
Just like when liquidity dried up in the markets due to the ban of short selling, just like how no corporate other than a steller credit can issue debt at anything under usury, now who will get a rate any other place then the new and improved public trough?
And this 'shutdown' of competitive markets results in the liquidity sponge that strengthens the attractiveness of the sovereign credits, Treasuries -real and synthetic (FDIC guaranteed).
Which perversely allows the Federales to keep their financing costs down even as they devalue the scrip that will be used to pay it.
(As an aside if a protection seller of CDS on Treasuries is effectively creating a synthetic bond, is the buyer shorting because given this monetization strategy you can't short the real?)
Agreed. You cannnot hedge a US Treasury/USD collapse.
The bright side is that a US government default is NOT the end of the world. Countries from Argentina to the Roman Empire defaulted without a Mad Max scenario evolving; just much hardship and the wiping out of most savings.
A US default would mean the end of the current monetary system. Essentially, all liquid assets would fall to zero. The logical trade would be to buy hard assets. However, experience shows us that those hard assets also get seized through extreme taxation and expropriation. The simple fact is that the government and the mob will not allow you to be wealthy while they starve. So, if we reach that point, it is essentially pressing the reset button on global wealth. A barter economy would evolve for a couple of years, just like it did during the Soviet collapse, then a new currency would emerge.
My point, is two fold. First, it would be bad, but it would not be the end of the world. Second, there is precious little you can do if that scenario unfolds.
And no, guns and ammunition are not a good hedge. They will not stop the government from expropriating you, though it may be a wise move in a high crime environment.
This dollar rally may last for years . . .
It's been building up for a long time.
http://www.zerohedge.com/forum/market-outlook-0
Grand I agree. The natural course is raging deflation as deleveraging continues. However, we have to recognize the possibility that that the government will directly print money to offset asset price declines. That would lead to the above mentioned raging inflation and a USD / USD collapse.
This is now essentially a policy choice. Do governments prefer inflation or deflationary economic hardship?
I believe they will go down the deflationary road because long-term it is less costly, but I am worried they may continue on the inflationary road because it is easier to sell on a short-term basis.
Is that you, Liesman?