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

84 A Market for End-of-the-World Insurance? Credit Default Swaps on US Government Debttors can deter this kind of behavior by writing loan covenants thatprohibit it, but this remedy may be impractical due to monitoringcosts and collective-action problems. 40Besides its distributional impact on investors, correlation-seeking inthe market for CDS on USA would generate social costs. Becausethe protection sellers’ shareholders would bear little of the expectedliability on the CDS contracts, managers whose goal is to maximizeshareholder wealth would be willing to cause their firms to sell thecontracts at artificially low prices, thereby undermining the market’sdiscovery function. The distortion would be especially severe giventhat the protection sellers would lack the normal incentive to chargea premium for systematic risk. Underpricing could also cause CDSsales to be concentrated in those firms whose solvency is most tightlylinked with that of the US Treasury and which therefore can profitmost from correlation-seeking.The possibility of risk concentration suggests that the market forCDS on USA could evolve to look quite different from the marketfor CDS on Greek sovereign debt pre-March 2012. As noted above,the Greek credit event seems not to have impaired the solvency of theprotection sellers, implying a market in which risk was well diffused.A contrast is offered by the 2008 financial crisis, in which three firmsthat had sold insurance on the default risk on mortgage-backed securities—AIG,Fannie Mae and Freddie Mac—suffered losses thatwould have bankrupted them but for large government bailouts.Losses at these firms were so severe because each had assumed aconcentrated position in the mortgage market. Thus, besides sellingCDS on mortgage-backed securities, AIG had invested large sumsin such securities directly. 41 And Fannie Mae and Freddie Mac, inaddition to selling guarantees on mortgage-backed securities, ownedextensive mortgage portfolios. 42 Of course, firms that concentraterisk in this way are more likely to fail if the risk materializes, with systemicimplications through their relationships with counterparties.To this point, the relative scarcity of CDS on USA suggests that littleif any correlation-seeking is occurring in that market. This does not40 Id. at 1182.41 Id. at 1186-87.42 Id. at 1192-96.