My pet conspiracy theory

[NorthSideSox72]

I work in finance and technology. I've come across something that makes no real sense, barring what I am theorizing here. Let's see what some of you think.

 

There are some people out there doing Credit Default Swaps (CDS), over US Treasury Bonds.

 

Why would you buy protection against the default of US T-Bonds? Before you answer, think it through to its logical conclusion.

 

There are two possible scenarios. One is that the US Treasury does not default on its debts (this is obviously the likely scenario). That happens, the money is gone. The other is that the US Treasury does in fact default. Now, if that happens, what that means is that the whole US financial system is going to crash. So effectively, even if you called the protection seller to cover the par on those T-Bonds, they aren't going to pay you anyway, even if they could (which they probably could not). So, again, the money is gone. Its like buying insurance that covers a nuclear holocaust - if it happens, the insurance company is gone anyway, or declares force majeur.

 

So... why? Why would you buy that protection? My theory: its a method of hiding cash flows. One financial entity wants to send cash to another one, to meet an agreement or contract of some kind that would not pass regulatory or legal muster. Something under the table. But by distributing the cash this way, the cash flow itself is clean. Nothing weird on the books.

 

I am looking for someone to punch holes in my theory here. Can anyone thing of a logical reason for doing this, other than what I am theorizing?

 

[kapkomet]

Who is selling, and who is buying? That would go a long way in proving your theory.

 

[NorthSideSox72]

Who is selling, and who is buying? That would go a long way in proving your theory.

I looked into that a bit on the interwebs (this is NOT something MY firm is doing - just something happening in the industry). Most of the firms doing it are domestic - not foreign entities. Which only adds to my theory.

 

Who could be buying protection in the US on US_T-Bonds where it would make any sense at all?

 

[DukeNukeEm]

The USSR did something a lot like this in the Cold War to get their hands on USD, they called them Eurodollars. I'm not sure exactly who else in the world wants USD's who couldn't get them (Venezuela? Iran?) but for them it's a total win/win. If the US Treasury doesn't default on loans the other governments get to trade in $'s and if we do default that's the global hegemony shift they've been praying for.

Edited May 12, 2009 by DukeNukeEm

[NorthSideSox72]

The USSR did something a lot like this in the Cold War to get their hands on USD, they called them Eurodollars. I'm not sure exactly who else in the world wants USD's who couldn't get them (Venezuela? Iran?) but for them it's a total win/win. If the US Treasury doesn't default on loans the other governments get to trade in $'s and if we do default that's the global hegemony shift they've been praying for.

I'm not talking about Currency swaps here - this is a credit default swap.

 

Party A holds a debt instrument (could be T-Bonds, or corp debt, or mortgage debt, etc.). They want to remove the default risk, so they take their return rate (i.e. 7%), and pay some portion of that (say 2%) to someone else. That someone else, the SELLER of protection, gets the cash flows. In exchange, the protection BUYER, gets the right to PUT the defaulted loan to the SELLER, in exchange for full par value.

 

What you were describing is a currency swap, which is a different deal.

 

[Texsox]

I'm not one of the finance guys around here but, IIRC, bonds issued prior to 1985 could be called without the treasury paying the full interest. Perhaps this applies to those bonds?

[NorthSideSox72]

I'm not one of the finance guys around here but, IIRC, bonds issued prior to 1985 could be called without the treasury paying the full interest. Perhaps this applies to those bonds?

CDS swaps only insure the par value of the bond, not the interest coupons - at least the ones I am familiar with. Swaps are one-off contracts, so I suppose one could write stipulations into it regarding coupon non-payment.

 

 

[Texsox]

CDS swaps only insure the par value of the bond, not the interest coupons - at least the ones I am familiar with. Swaps are one-off contracts, so I suppose one could write stipulations into it regarding coupon non-payment.

 

Then shall we explore a type of "default" similar to that in the 1930s when Bonds were no longer guaranteed in gold? Perhaps this is insurance that the US T will not make fundamental changes in the terms like increasing the time to yield?

 

Am I sounding like an idiot yet? I am such a small time investor, and this is clearly big time issues.

[NorthSideSox72]

Then shall we explore a type of "default" similar to that in the 1930s when Bonds were no longer guaranteed in gold? Perhaps this is insurance that the US T will not make fundamental changes in the terms like increasing the time to yield?

 

Am I sounding like an idiot yet? I am such a small time investor, and this is clearly big time issues.

If the US Treasury changed the underlying bond guarantee structure, its still not a default. Its a default if they cannot make obligated coupon payments and/or they cannot pay back the principle.

 

[G&T]

2 questions:

 

What is the normal interest rate on such transactions and over what period of time?

 

Do companies usually make these agreement only to one form of debt in each contract, or to multiple debts in the same contract?

[Texsox]

If the US Treasury changed the underlying bond guarantee structure, its still not a default. Its a default if they cannot make obligated coupon payments and/or they cannot pay back the principle.

 

Unless we see the terms of the insurance, are we certain any of those scenarios would not be covered? I am thinking your car does not need to be totaled, for insurance to kick in.

 

By calling the bonds, are they not making the obligated coupon payments?

[NorthSideSox72]

2 questions:

 

What is the normal interest rate on such transactions and over what period of time?

 

Do companies usually make these agreement only to one form of debt in each contract, or to multiple debts in the same contract?

There really is no "normal" rate, it is dictated by market forces. The swap cash flows are generally made in the same periodicity as the underlying debt instrument, but not necessarily (as, again, there are typical structures, but each swap is a different contract that can have nuances).

 

The debt that is swapped is a "package". It could be a single large bond, like a corporate bond. Or it could be a securitized bundle of debts, like a collection of car loans, for example. If it is a single debt instrument, the option to put the bond on the protection seller is a simple question of whether or not that instrument went into default. If it is a bundle of debts, then it can be more complex - there may be a threshold in the contract for how much of the par went into default, or other scenarios.

 

For T-Bonds, you would swap a given par amount of Bonds. So it acts like a single instrument.

 

[NorthSideSox72]

Unless we see the terms of the insurance, are we certain any of those scenarios would not be covered? I am thinking your car does not need to be totaled, for insurance to kick in.

 

By calling the bonds, are they not making the obligated coupon payments?

First part - nothing is certain. One could insure the interest payments only I suppose. But think about that for a second. Unless the Treasury instrument was intended to be variable in any fashion as to coupon payments (i.e. TIPS), then if they can't make payments, they are in default anyway.

 

Second part - I don't see where you are going there.

 

[Texsox]

Second part - I don't see where you are going there.

 

The treasury reserves the right on some bonds issued before 1985 to stop paying interest before the bonds mature. These were at a very high interest rate, think double digit interest.

 

If they do call those, and stop paying the interest, could that be considered a "default". And it has been happening annually for a few years.

[G&T]

There really is no "normal" rate, it is dictated by market forces. The swap cash flows are generally made in the same periodicity as the underlying debt instrument, but not necessarily (as, again, there are typical structures, but each swap is a different contract that can have nuances).

 

The debt that is swapped is a "package". It could be a single large bond, like a corporate bond. Or it could be a securitized bundle of debts, like a collection of car loans, for example. If it is a single debt instrument, the option to put the bond on the protection seller is a simple question of whether or not that instrument went into default. If it is a bundle of debts, then it can be more complex - there may be a threshold in the contract for how much of the par went into default, or other scenarios.

 

For T-Bonds, you would swap a given par amount of Bonds. So it acts like a single instrument.

 

Here's my issue: if I'm a seller in a possibly illegal transaction, I want the money moved quickly rather than waiting for my money to slowly come in. The problem is if the buyer isn't gaining anything on the deal and becomes unhappy, he could simply stop payments and the seller would have no recourse because the underlying contract was illegal. And even if the seller claims that the buyer did not make proper installment payments on the protection, this will bring the books to the attention of the court which will eventually find that something is amiss.

As a result, the deals must be for low prices which can be covered by the low interest rate. I guess the question is, how much money is actually being swapped and would it be worth it to make such illegal deals.

 

The other option is to hold the up front payment somewhere and slowly wash it over a period of years, but again, the longer it takes to clean the money, the higher the chance of getting caught.

 

I'm not a finance person, so I'm trying to apply practical principles.

 

I think there are too many "ifs" in all this. Unless we see the transaction nothing can be certain.

 

[NorthSideSox72]

The treasury reserves the right on some bonds issued before 1985 to stop paying interest before the bonds mature. These were at a very high interest rate, think double digit interest.

 

If they do call those, and stop paying the interest, could that be considered a "default". And it has been happening annually for a few years.

That's not a default, that is a variable rate instrument. Its a known outcome - nothing to insure.

 

[NorthSideSox72]

Here's my issue: if I'm a seller in a possibly illegal transaction, I want the money moved quickly rather than waiting for my money to slowly come in. The problem is if the buyer isn't gaining anything on the deal and becomes unhappy, he could simply stop payments and the seller would have no recourse because the underlying contract was illegal. And even if the seller claims that the buyer did not make proper installment payments on the protection, this will bring the books to the attention of the court which will eventually find that something is amiss.

As a result, the deals must be for low prices which can be covered by the low interest rate. I guess the question is, how much money is actually being swapped and would it be worth it to make such illegal deals.

 

The other option is to hold the up front payment somewhere and slowly wash it over a period of years, but again, the longer it takes to clean the money, the higher the chance of getting caught.

 

I'm not a finance person, so I'm trying to apply practical principles.

 

I think there are too many "ifs" in all this. Unless we see the transaction nothing can be certain.

Those are very good points, especially about the trickle of cash flows.

 

But, again... no one seems to be able to give me a financially meaningful reason for doing it. I don't just mean here - I mean, no one I've talked to, even in finance, can do it.

 

[juddling]

you know from the thread headline i could have sworn the discussion was about my dogs plotting to get rid of me!!!!

 

[Texsox]

That's not a default, that is a variable rate instrument. Its a known outcome - nothing to insure.

 

As you mentioned earlier, there should be nothing to insure here, so we are kind of grasping at straws. I was about to suggest it would be like buying hurricane insurance in Illinois.

 

There are only two things to insure here, the principle and/or the interest. It seems to me that it makes more sense for there to be a secondary market built around the interest than the principle.

[G&T]

This is from a faculty blog from a professor at Northwestern in response to same question asked in this thread:

 

Yes, CDS on US Treasuries have recently been in the range of 30 basis points. Your points are good ones and I don’t have great answer. Several comments:

 

1. I asked several traders about this market when I first heard about it and their guess was that these trades are sovereign-to-sovereign (or at least written by a sovereign).

 

2. The US Govt did apparently almost suffer a techncial default in 1996 when the Republicans refused to approve the budget (Washington shut down for a week or two at that time, don’t remember the details). Even if there were a technical default, however, loss given default would be approximately zero.

 

3. The quantity is small. The DTCC shows 4 billion notional gross and a little over 1 billion net. It’s not a huge market, but it is a market.

 

So yes, it’s odd. I don’t have a good explanation.

 

Bob

 

Linky. It's in the comments.

[NorthSideSox72]

This is from a faculty blog from a professor at Northwestern in response to same question asked in this thread:

 

 

 

Linky. It's in the comments.

So even this Kellogg faculty prof doesn't have a good answer.

 

Still seems fishy to me, though the numbers are small. I wouldn't expect them to be huge though, even if it is a bogus money laundering scheme, because it would draw too much attention.

 

[Balta1701]

I'm not sure if it's on the same subject or not, but there is a real effort by bond-issuers to screw government entities that issue bonds. A government entity, whether federal, state, or local, typically defaults on its bonds at much lower rates than private bonds...yet, they wind up paying the same or often higher levels of interest to secure that financing.