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

70 A Market for End-of-the-World Insurance? Credit Default Swaps on US Government DebtCurrently, a much smaller percentage of US government debt iscovered by CDS than is the debt of other large sovereign borrowers.To many observers, the relative paucity of CDS on US Treasurydebt—called here “CDS on USA”—has a simple explanation: counterpartycredit risk. CDS protection sellers tend to be large financialinstitutions, many of which might end up insolvent if the US everdefaulted on its national debt. The implication is that CDS on USAis like end-of-the-world insurance sold by Earth-bound insurers. Ifthe world actually blew up, surely it would take the insurers with it.While this standard explanation for the relative scarcity of CDS onUSA has a superficial appeal, it is based on a misunderstanding ofwhat actually happens under US insolvency law when a firm withopen derivatives positions fails. Rather than recovering nothing, thefirm’s derivatives counterparties enjoy preferential treatment thattypically ensures them substantial payouts on their claims. Thus,even if there is a strong correlation between the risk that liabilityon a CDS contract will be triggered and the risk that the protectionseller will then be insolvent, it does not follow that the contract hasno value. The explanation for the unusual thinness of the market forCDS on USA seems to lie elsewhere.A high correlation between the liability risk on a CDS contract andthe protection seller’s insolvency risk does, however, have a different—andmore troubling—implication. The shareholders of such aprotection seller enjoy the upside from the CDS sale, as the feescharged to the protection buyer augment the seller’s profits. Andthe shareholders are indifferent to the possibility that liability on thecontract will be triggered, because by assumption the seller will thenbe insolvent anyway. Thus, the downside on the contract is borne notby the seller’s shareholders but rather by its general creditors, whoserecoveries from the protection seller’s bankruptcy estate are dilutedby the protection buyer’s recovery. Besides transferring expected valuefrom creditors to shareholders, CDS sales of this type can distortmarkets, causing CDS prices to understate the probability of defaulton the reference debt, and CDS liability to be concentrated in ahandful of systemically important firms.