Credit Default Swaps Do Not Insure U.S. Debt

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Sunday, 24 July 2011 21:21

Suppose an insurer in New York sold insurance against a nuclear bomb being dropped on the city. Is this insurance against nuclear war?

As a practical matter, only a fool would think that this covered his financial bases. If there were actually a nuclear bomb dropped on New York, this New York based insurer would almost certainly be destroyed along with whatever it had insured.

This is the same deal as with credit default swaps on U.S. debt. If it turns out that the United States defaults on its debt (meaning a true default,  where bonds are not paid, not a technical default where there is a brief delay in payment), then it is very questionable whether any financial institution issuing the CDS will be around to pay it off. That is the case not only with U.S.-based financial institutions. Even banks in Europe and Asia would be badly shaken by a default on U.S. debt.

Therefore the NYT is misleading its readers in a chart accompanying this article that presents the price of CDS on U.S. debt as a measure of the price of buying insurance against default. Since this is not real insurance, this can more accurately be viewed as the price of a bet on some sort of default event that could allow someone to get into court with a claim. If a holder of CDS can get through the door on arguing for a claim, the issuer may pay them to just go away.