May 07, 2015
A post by Paul Krugman on the price of credit default swaps (CDS) on bonds issued by the United Kingdom reminds me of the dark days of the financial crisis when otherwise serious people used the price of CDS on U.S. Treasury bonds as a measure of the risk of a default by the U.S. government. With the price of the CDS rising, we had some of these people getting very concerned about the prospect of a default.
As the more calm among us tried to explain, it’s not clear that the price of a CDS on U.S. Treasury bonds measured anything. A person holding the CDS can only get paid off, if the U.S. government defaults on its debt and the bank that issued the CDS is around to make the payment. If there is a real default (I don’t mean a delay of a few hours or days over debt ceiling fights), it is hard to imagine what banks would still be standing to make good on the CDS they had issued.
In other words the probability that the U.S. government would default and there would be bank in a situation to meet its CDS obligations is very close to zero. This is why the price of a CDS issued on U.S. Treasury bonds is virtually meaningless as a measure of default risk.
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