To be honest there were countries that defaulted on their sovereign bonds in their home fully controlled currency. Russia did this in the late 90s and took down LTCM, which was collecting premiums for insuring something that they thought is too illogical to ever occur. Well, it did occur.
The reason why this is illogical is that there is very little distinction between "the dollar" and US sovereign debt. It applies to all countries in a similar situation, for example "the Yen" and Japanese Government Bonds. It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.
What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit.
However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory.
But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt.
However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it.
> It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.
While that's true, Spain could go the tax route and say "gimme more euros this year" or sell off assets it owns. I guess a printer is faster (if they feel like it) but medium-term, developed countries have lots of tools to pay down debts (if they feel like it).
For some reason, people are more comfortable with inflation as a tax than taxes.
This is an extremely relevant Matt Levine piece. He gives an example of long-dated treasuries trading at 83 cents on the dollar. Today long-dated treasuries issued during COVID are trading well into the 50ies.
That's not because of their credit risk but because they pay little to no coupon and get discounted through the interest rates. In particular imagine a treasury bond that will pay $100 in 10 years, you wouldn't pay $100 for that, would you? You'd instead put that $100 in a savings account (t-bills).
The true credit risk on US Treasuries is indeed an abstract and mysterious creature. Nobody knows what would such a "default" mean in practice, what paper would get paid up and what paper would not get paid. Would commercial bank deposits at the Fed get paid? And if not, then what does it even mean to "pay in dollars"? Like how do you achieve "paying someone X dollars", do you deliver printed currency?
The way I understand the article: Insurance not likely to pay in case of small short cured default and in a major default the counterparty is at risk. So buying it as insurance makes no sense. But..
.. there are special rules which trigger even in a short default allowing a fair bit of money to be made turning the CDS into a sensible bet on a short duration US default.
H8crilA|2 years ago
The reason why this is illogical is that there is very little distinction between "the dollar" and US sovereign debt. It applies to all countries in a similar situation, for example "the Yen" and Japanese Government Bonds. It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.
btilly|2 years ago
What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit.
However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory.
But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt.
However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it.
Scoundreller|2 years ago
While that's true, Spain could go the tax route and say "gimme more euros this year" or sell off assets it owns. I guess a printer is faster (if they feel like it) but medium-term, developed countries have lots of tools to pay down debts (if they feel like it).
For some reason, people are more comfortable with inflation as a tax than taxes.
whitemary|2 years ago
Thanks for coming clean.
khuey|2 years ago
H8crilA|2 years ago
The true credit risk on US Treasuries is indeed an abstract and mysterious creature. Nobody knows what would such a "default" mean in practice, what paper would get paid up and what paper would not get paid. Would commercial bank deposits at the Fed get paid? And if not, then what does it even mean to "pay in dollars"? Like how do you achieve "paying someone X dollars", do you deliver printed currency?
heisenbit|2 years ago
.. there are special rules which trigger even in a short default allowing a fair bit of money to be made turning the CDS into a sensible bet on a short duration US default.