Thursday, October 2, 2008

Will U.S. Treasury bonds default one Day?

From NEW YORK (Fortune):

What odds would you lay that Uncle Sam is going to be a deadbeat?

Until a few weeks ago, that sounded like a ludicrous question. And even amidst bailout insanity, the market has shown that the vast majority of investors still hold the view that U.S. Treasury bonds are the safest of safe havens, the kind of investment you'd bring into your bunker in the event of a nuclear attack.

But a few skeptics are willing to put their money where their doubts are.

One day after the failure to pass a Wall Street bailout plan sent the bond market into convulsions, skittishness about Uncle Sam's prospects was felt in the market for credit default swaps, insurance-like contracts in which buyers pay a premium and sellers agree to compensate them in the event of a specified event - most often the default of a bond.

In New York trading Tuesday, prices rose to a record 31.3 basis points (each basis point is 1/100 of a percentage point) to "insure" Treasury debt, compared to as little as 7.5 basis points in January, according to information provided by CMA DataVision.

In other words, it would've cost you $7,500 per year to protect $10 million in Treasury bonds in January - but $31,300 today. Of course, even the latter figure remains negligible compared to, say, the $2 million up front - plus $500,000 per year - that you would have needed to pay for the same amount of default swap protection on Morgan Stanley (MS, Fortune 500) bonds when the firm was under fire two weeks ago. But the increase is telling nonetheless.

A wild market
Credit default swaps are a wild, unregulated market - see "The $55 Trillion Question" - in which participants make bets on the failure of corporate bonds, municipal bonds and, yes, U.S. government bonds.

Default swaps on U.S. bonds have been bought and sold for at least four years, says Simon Mott of CMA DataVision. But the market is still little known. One prominent trader in U.S. debt, when asked about swaps on Treasurys, expressed surprise and started asking co-workers, "Did you guys know that there are credit default swaps on U.S. bonds"? (The other traders seemed to know, though one could be heard saying "it's the biggest joke" in the background.) U.S. government issues are not the only sovereign debt covered by swaps. Large banks such as JPMorgan Chase (JPM, Fortune 500) will match swap buyers and sellers for, say, U.K. debt or Icelandic government bonds.

Prices on U.S. government swaps may have peaked - at least for a day or two. The underlying market for U.S. bonds seemed to be stabilizing Tuesday, according to Tom di Galoma, the head of U.S. Treasurys trading at Jefferies & Co., as investors began anticipating that the government will provide some form of relief for the holders of toxic mortgage debt would pass. "We've seen the low in yields," di Galoma says. "Who else can go out of business at this point?"

Of course, if the past month has taught investors anything, it's how unsettling the answer to that question can be. But the U.S. failing to make its payments? Now that would be a shocker (yes, a Moody's spokesman confirms that it re-affirmed the U.S. government's AAA rating last week). And if it did, the swap player who bet the right way may not feel much like celebrating

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