Betting $4.8 billion on a U.S. default

By Annalyn Censky @CNNMoney

NEW YORK (CNNMoney) — With its winners and losers, Wall Street is often likened to a big casino for obvious reasons. And even when it comes to a possible U.S. default next week, at least a few financial players are looking to cash in on such a bleak turn of events.
A small camp of investors are betting that the U.S. government will default on its debt, and they’re putting $4.8 billion of their chips on the table.

In the event of a default, that’s how much financial firms will have to pay out to investors who bought credit default swaps against the U.S. government, according to figures from the Depository Trust and Clearing Corp.
With only a week to go until the government breaches its debt ceiling, are these few investors likely to come away with the winnings of a lifetime?
Probably not, experts say.
“I think we’re a long way away from considering this hypothetical [case],” said Otis Casey, director of credit research at Markit.

Debt ceiling: What happens if Congress doesn’t raise it?
A credit default swap, or CDS, is basically an insurance contract against a default, and in this case, $4.8 billion is quite meager in comparison to what those on the other side of the bet are putting down.

Private investors — including everyone from individual consumers to hedge funds to the Chinese government — currently hold $9.3 trillion (with a T!) in Treasury bonds, and they’re counting on Uncle Sam paying up when those contracts mature.
But if they’re wrong to count on the “full faith and credit of the U.S. government” and the U.S. stops paying bondholders principal and interest, Treasury investors could lose some of those funds.

In contrast, the small group of CDS investors could demand payment from the investment banks that sold them their “insurance” contracts.
Even then, the U.S. would have at least three days to make up for missed debt payments before banks would have to pay out to CDS holders, said Steven Kennedy, spokesman for the International Swaps and Derivatives Association.
CDS contracts typically have a three-day grace period, he said. Plus, even though 1,037 CDS contracts are currently held against the U.S. government, they all expire at varying deadlines. (CDS contracts typically cover a 5-year period.)

Debt ceiling fight: What a downgrade would mean
Kennedy also points out that even if a major ratings agency declared that a default had occurred, various criteria would still have to be met before what’s known as a “credit event” occurred under the CDS terms.
The definitions of default by the rating agencies and under the CDS contracts are “two different animals” he said.
When considering CDS, a default happens only if the U.S. were to stop paying principal and interest to its bondholders, refuse to acknowledge its bond contracts or restructure its debt.

Even then, CDS holders would still have to jump through hoops to get paid. They would have to file for an official review from the ISDA Determinations Committee to determine whether a credit event has in fact occurred.
That board currently includes 15 of the world’s largest financial firms, including Bank of America, Goldman Sachs, JPMorgan Chase, Deutsche Bank and others — which don’t exactly have an interest in a U.S. default.
If a default actually happened, these banks would be dealing with bigger problems of their own — including a financial crisis so massive it could quite possibly bring them down, said Dean Baker, co-director of the Center for Economic and Policy Research.
“Everyone is so heavily dependent on U.S. Treasuries that we would certainly see a Lehman-type freeze-up or even much worse,” he said, likening credit default swaps against the U.S. government to taking out insurance against a nuclear bomb.

“Only a fool would think that this covered his financial bases,” Baker said in a blog post.

The cost of buying a CDS swap protecting against a U.S. default was at a 0.6% premium Tuesday.
While that price has risen from 0.52% premium at the beginning of the month, it’s still at a level that shows traders view Treasuries as a very safe bet, Casey said.

In contrast, it costs a 16.45% premium to insure against Greece’s junk-rated debt.