US Government Debt Different - Finance Department - University of ...

Richard Squirewill default. An economic report from the Congressional ResearchService named this type of counterparty risk as the primary reasonthat CDS on USA is scarce, arguing as follows: “Were a serious Treasurydefault to occur, major US banks could face severe deteriorationin their capital bases, leaving their ability to make CDS paymentsin doubt.” 21 Along the same lines, an article in The Daily Beast byDaniel Gross offered an analogy:79Does it make sense to buy insurance against, say, a nuclear attackon Washington—if all the insurance providers’ headquarters areinside the Beltway? Of course not. So why do investors buy insuranceon US government debt? 22Indeed, the real question for Gross was not why the market for CDSon USA is so thin, but rather why anyone would buy such insuranceat all. 23While the metaphor of a nuclear attack is vivid, it is also misleading.When a financial firm fails it does not disappear in a cloud of dust.Rather, it is unwound in an insolvency proceeding that distributesits assets to its creditors. And at least under US law, counterpartiesof a failed CDS protection seller enjoy a preferred position in thedistribution queue. 24 Thus, CDS positions tend to be collateralized,and several provisions of the US Bankruptcy Code protect the abilityof derivatives counterparties to seize and liquidate posted collateral.First, the Code exempts counterparties from bankrutcy’s automaticstay, permitting them to terminate their contracts and liquidate postedcollateral immediately. 25 Second, the counterparties are exempt21 Austin & Miller, note 5 above.22 Daniel Gross, The World’s Strangest Financial Instrument, The Daily Beast(March 16, 2010, 8:00 PM), available at http://www.thedailybeast.com.23 Id. (asking, “Why does anyone buy insurance policies that pay off only if the USgoes bankrupt?”).24 See David A. Skeel, Jr. & Thomas H. Jackson, Transaction Consistency and theNew Finance in Bankruptcy, 112 Colum. L. Rev. 152, 154 (2012) (describing the“privileged status of derivatives and repos” under US bankruptcy law); Edward R.Morrison & Joerg Riegel, Financial Contracts and the New Bankruptcy Code: InsulatingMarkets from Bankrupt Debtors and Bankruptcy Judges, 13 Am. Bankr. Inst. L.Rev. 641 (2005).25 11 U.S.C. § 362(b)(17).