Credit default swaps (CDS) are a form of insurance. Let's say you borrow money from me. I'm worried that you might default. So I hedge that risk by purchasing a CDS. If you end up unable to pay me back, the seller of the CDS will cover my losses. (The insurance analogy admittedly is not exact, but it suffices for present purposes.)
Like any form of insurance, as the probability of the event occurring rises, the cost of the CDS rises.
So what are we to make of the fact that the price of credit default swaps on US Treasuries has been rising lately?
A poster at Dealbreaker.com opines that:
Unless you can collect the protection in Swiss Franc, we find it difficult to get our head around credit default swaps on U.S. Treasuries. Surely, if you find yourself actually needing the protection, the last thing you want is U.S. Dollars. And in addition, if you find yourself in a position to expect payment from your counterparty, how likely are you to get paid? And finally, why in the world would the U.S. choose to default, rather than just turn on the printing presses?
Likewise, The Economist's Buttonwood column opines that:
Investors should also ask whether it makes sense to insure against a default on Treasury bonds. If the American government defaults, which bank will still be good for the insurance claim?Points all well taken. Although sovereign defaults are hardly unknown, things would have to get incredibly bad for the US to default on Treasuries. And if they got that bad, you'd probably have been better off investing in a survivalist camp than CDSs.
Having said all that, however, the rise in the cost of insuring against a US default is worrisome. It's a highly negative signal from the market. People are willing to bet that the USA can't get its financial house in order. Peggy Noonan is hardly a great economist, but I think her WSJ column today captures at least some of what's happening in the sovereign CDS market:
People are freshly aware and concerned about the real-world implications of a $1.6 trillion dollar deficit, of a $14 trillion debt. It will rob America of its economic power, and eventually even of its ability to defend itself. Militaries cost money. And if other countries own our debt, don't they in some new way own us? If China holds enough of your paper, does it also own some of your foreign policy? Do we want to find out? And there are the moral implications of the debt, which have so roused the tea party movement: The old vote themselves benefits that their children will have to pay for. What kind of a people do that?
The CDS market is sending us a signal. Do we have the will to listen?