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Credit Default Swaps – What Are They and What Do They Teach Us About the Risk of the U.S. Dollar?

Last week, I got a phone call from a finance person telling me to consider moving treasuries that were coming due to the sidelines temporarily given the debt ceiling debate. This week we will discuss why I got the phone call and what you should consider doing.  – Dr. Nirav H. Shah

 

Overview

Credit Default Swaps are rising quickly, implying that the risk of United States Government default is rising. The Chicago Federal Reserve estimated a 4% risk of U.S. government default which would have worldwide ramifications.

Just like banks have failed, the probability of US Default is increasing which means you may want to reconsider allocating capital to treasuries until the debt ceiling is resolved.

 

What is the U.S. Debt Ceiling?

The debt ceiling is how much Congress will let the country borrow. 

On Jun 1, 2023, the debt ceiling will expire, and if Congress does not approve raising the ceiling of the amount of capital we can borrow, the U.S. dollar will default.

U.S. Debt has been rising quickly since the 2000s when we last achieved a budget surplus from 1998-2001. Fast forward to wars in Iraq, Afghanistan, Russia, the Great Financial Crisis of 2008, and quantitative easing during COVID in 2020. 

 

 

Figure 1. This view comes from the Congressional Budget Office:

 

As a result of rising U.S. debt, it has approached 100% of our GDP requiring Congress to raise the debt ceiling.

 

Figure 2: This chart from the World Economic Forum demonstrates how quickly our debt has risen in the red bars compared to our GDP in the blue line.

.

What is the X-date?

As of last May 18 2023, the U.S. had <$60 billion in its treasury cash balance. While the amount on the balance sheet fluctuates just like your own bank account might, this is the lowest reserve the country has had in over a year. Generally, the balance sheet is meant to be above $150 billion according to Ben Harris, who served as assistant Treasury secretary for economic policy until recently.

Treasury Secretary, Janet Yellen, has called June 1xt the X-date. That’s when the U.S. will not be able to continue paying its bills. The current debt ceiling is set at $31.4 trillion, legally limiting how much the treasury can borrow.

 

Why should you care about the U.S. Debt and Deficit Spending? 

Taxes, that’s why! 

The U.S. deficit implies significant risk of higher taxes. As higher income earners, healthcare workers and physicians are particularly at risk on your path to FIRE. The deficit has also contributed to inflation and higher interest rates.

Given the U.S. has had to borrow money, it has had to increase the money supply which has led to higher prices. The only other way to balance the budget is to cut spending, but historically this is a difficult and complicated topic. While it may seem like the government is spending more, in some ways, it has been cutting discretionary expenses as a proportion of total expenditure. 

 

 


Sixty percent of mandatory spending was for Social Security and other income support programs. Most of the remainder paid for the two major government health programs, Medicare and Medicaid.

As a result of this constraint, recently Congress has had to approve increasing the debt ceiling which has led to market volatility and uncertainty as both parties use the negotiation to advance their partisan agenda. 

An important risk indicator has recently risen which is the price of Credit Default Swaps. We’ll describe them and explain why you should care and what you might consider doing briefly if you hold treasuries.

 

What is a Credit Default Swap?

A credit default swap (CDS) is basically a way to insure a debt such as a bond or U.S. Treasury. They were an important part of the banking crisis in 2008 leading to the Great Financial Recession. The CDS allowed banks to create derivative products to collateralize debts enabling betting on mortgage prices called mortgage back securities. American International Group (AIG), Bear Stearns, and Lehman Brothers issued these CDS for mortgage-backed sorceries The CDS became insolvent leading to bank collapses when the mortgage collapse occurred.

Here is a video summary of CDS’ in under 2 minutes.

Treasuries and bonds have risks of default. A CDS can shift the risk, whether low or high to a CDS seller for a premium.There are 3 parties to a CDS:

  1. CDS Buyer (Bank)
  2. Bond issuer (US Government Treasury)
  3. CDS Seller (Hedge Fund)

Let’s say a U.S. treasury is for sale. The interest rate of the US. Treasury is to be paid to a buyer at the maturity of the term. Implicitly, this means the U.S. Government will pay the premium back to a buyer of a treasury bill. Since there is a chance the treasury may default a CDS could act as insurance for the potential default.

Institutions like banks that are buying treasuries and bonds may purchase CDS from sellers that are typically hedge funds.

 

Why are CDS Premiums rising?

Recently, CDS prices have been rising quickly as the debt ceiling approaches.  The debt ceiling has been raised 78 times since 1960. The most recent increase was in December 2021, when the debt ceiling was raised by $2.5 trillion to $31.381 trillion. 

The debt ceiling is expected to be raised again in early June 2023 but the rise in  CDS prices has sent some alarm bells throughout the finance community.

 

This chart is the price of a 1-month treasury that shows how quickly the interest rate has risen. 

 

What do rising Credit Default Swap Premiums imply?

This fast rate of rise implies that the risk of U.S. Default is significantly higher than before.

 

 

The Chicago Federal Reserve published a paper that assesses the liquidity of treasuries, the rising premiums of CDS, and what the data implies. Based on their analysis the implied risk of default is increasing to ~4% in May of 2023.

This data should be cause for concern. Even if we get through this period and raise the debt ceiling, we as a country will have to consider this again in 2024.

 

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What should you consider – high-yield interest options, sell treasuries, buy treasuries?

All in all, if you have capital in treasuries, consider moving them to a money market fund or a high-yield bank account like Panacea:

We also discussed I-bonds, which earn >4% for the next six months. 

Should you sell treasuries if they’re not maturing? Hard to say, but, in general, it’s probably not worth it as you may be selling them at a loss.  

If you’re interested in some higher yield, you could also consider purchasing them. The range of 1-6 months treasuries at 5.6% is quite attractive given the likelihood of U.S. Default is still low at the time of this writing. 

 

Conclusion:

Overall, I think we will likely get through this and Congress will approve raising the debt ceiling. However, it is becoming an important issue for our country to consider.

We’ve discussed our status as a wavering reserve currency.  We also know that our country needs to start balancing the budget otherwise we will continue to have this issue and the consequences to us as individuals working hard, paying taxes, and saving could be quite bad.

 

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3 thoughts on “Credit Default Swaps – What Are They and What Do They Teach Us About the Risk of the U.S. Dollar?”

  1. Should have waited to hit send until the end.

    “The debt ceiling is expected to be raised again in early June 2023”
    What?! You said it “expired” on 1 June 2023.

    “Even if we get through this period and raise the debt ceiling, we as a country will have to consider this again in 2024.”
    How do you know? Congress decides when they will do this next. Democrats are pushing for 2025 or later. Republicans are pushing for 2024 (to make it an election issue).

    Is everything good? Quality has not been good the last few posts.

    Reply
    • Right – x-date refers to ‘expiration.’ While technically it’s not expiring that’s why many people and news outlets are saying it’s ‘expiring.’
      The McCarthy bill is to raise it through 2024 so we will have to revisit it next year unless something changes.
      Thanks for the critique, they help us.

      Reply
  2. Subscribe to get more great content like this, an awesome spreadsheet, and more!
  3. “On Jun 1, 2023, the debt ceiling will expire…”

    The debt ceiling does not expire. It has a maximum amount which has already been reached. The federal government has been doing “extraordinary measures” to not borrow more money but those measures are running out. It is estimated to happen 1 June.

    Reply

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