Default Could Spark Even More Investor Confusion

Tuesday, 26 Jul 2011 03:12 PM

 

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A U.S. debt default could send the derivatives market designed to protect bond investors into confusion because a missed Treasury payment may have been deemed too unlikely to be fully planned for in the contracts.

If the United States does default, investors that sold protection in the form of credit default swaps would theoretically need to pay out around $4.77 billion to buyers, based on outstanding net volumes from the Depository Trust & Clearing Corp.

With lawmakers are facing an Aug. 2 deadline to raise the $14.3 trillion U.S. debt ceiling and avert default, some in the industry now question what constitutes a default and whether CDS payments would occur immediately, or if the government would have time to make up a default.

A key issue is whether a grace period for the United States to cure the debt is associated with the credit default swaps, as is sometimes the case with similar derivatives contracts.

"There does not appear to be clarity about grace periods on Treasuries and we are currently researching this issue," David Geen, general counsel at trade association the International Swaps and Derivatives Association, told IFR, a Thomson Reuters service.

Some market participants said that as the Treasuries themselves do not specify a grace period, payments would be triggered as soon as a maturity or interest payment is missed.

Others, however, said that in this case alternative rules giving three days grace should be implemented.

With the issue unsolved, market anxiety may be heightened over the U.S. debt talks.

But even though there is no transparency over who has sold U.S. protection, any losses are likely to be contained as the outstanding CDS volumes are far below the more than $9 trillion in marketable Treasuries outstanding.

In return for paying out the insurance, sellers of protection would receive the value of the contract in Treasuries, which even if valued below par are still likely to be worth at least 90 percent of their value, traders said.

 

INSURING SAFETY?

But any confusion on actual payouts could add to questions over the effectiveness of CDS in insuring U.S. Treasuries, which have traditionally been considered the world's safest investment.

Until very recently, the notion of the United States government failing to meet its obligations has been deemed unthinkable and potentially catastrophic.

U.S. lawmakers were locked in a standoff on Monday over dueling debt plans that offered little prospect for compromise, increasing the threat of a ratings downgrade and national default that could sow chaos in global markets.

The cost of insuring U.S. debt in the credit default swap market rose to one-and-a-half year highs on Monday, even as doubts were raised over whether the contracts would even prove effective.

Some market participants said broader CDS definitions allow three days to cure any default, when no other period is specified in a contract.

Bret Barker, a portfolio manager at Los Angeles-based asset manager TCW Group, said most banks he has spoken to have come to a consensus that there should be a three-day grace period, though he noted "there was a little bit of confusion."

A U.S.-based committee of 10 dealers including Deutsche Bank, JPMorgan and Goldman Sachs, and five assets managers, including BlackRock, Citadel, and DE Shaw Group, will make the final decision over whether any default requires payments to be made.

U.S. CDS contracts are Europe-based and denominated in euros, due to the correlation between U.S. sovereign, dollar and bank risk.

If payments are made, protection buyers will give the sellers the value of the insurance in Treasuries.

Investors say, however, that at 58 basis points they continue to reflect still low expectations the United States will skip bond payments as lawmakers run up against the Aug. 2 deadline to raise the debt ceiling.

Another possible wrench in the works may be whether details of a skipped payment were made publicly available, according to ISDA's Geen.

"In order for there to be a credit event there has to be publicly available information that says this payment was due on this day and it wasn't made, and that may not be that easy to demonstrate," he told IFR.

Some market participants, however, see any potential default as likely to be very public, and that it would result in swift market reaction.

"I would think it's very hard to not make interest payments and for that it be left open to interpretation," said Priya Misra, head of U.S. rates research at BofA-Merrill Lynch in New York.

"The price of the securities would move drastically that day and you would see a tiering of next coupon securities would start underperforming much sooner," she said.

© 2014 Thomson/Reuters. All rights reserved.

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