Default Swaps Trading on U.S. Debt Doubles on Deficit Wrangling

U.S. Treasury Secretary Timothy Geithner
U.S. Treasury Secretary Timothy Geithner said the government will run out of options to avoid a default if the limit is not raised by early August. Photographer: Andrew Harrer/Bloomberg

Trading of credit-default swaps insuring U.S. Treasuries has doubled as the government struggles to agree on plans to cut its budget deficit and raise the $14.3 trillion national debt limit.

A total of 819 contracts covering a net notional $4 billion of debt were outstanding as of May 20, up from 449 contracts covering $2 billion a year ago, according to the Depository Trust & Clearing Corp. Average daily trading volume surged to $490 million last week from $10 million the week before, making the U.S. the fourth most active among 1,000 contracts tracked by DTCC, up from 633rd.

President Barack Obama’s administration is under pressure to resolve a standoff with Republicans over ways to reduce the deficit, or the federal government may lose its AAA credit rating, Standard & Poor’s said last month. Governments around the world are wrestling with deficit crises, with the European Union having had to rescue Greece, Ireland and Portugal.

“In a way, it’s worse than in Greece because no one can bail out the U.S.,” said Georg Grodzki, the London-based head of credit research at Legal & General Investment Management, which oversees $580 billion of assets. “Complete political paralysis is OK if your deficit is 3 percent, but not if it’s 10 percent.”

This year’s federal budget deficit is projected to reach $1.5 trillion, or 9.8 percent of gross domestic product, according to the Congressional Budget Office. The government will run out of options to avoid a default if the limit is not raised by early August, Treasury Secretary Timothy F. Geithner said May 2.

More Expensive

Swaps insuring Treasuries for five years are trading at 50 basis points, according to CMA. That compares with 37 basis points in April and a record 100 basis points at the peak of the financial crisis in 2009. One-year contracts are now more expensive than Panama, the Philippines and Mexico, CMA prices show.

Greek debt is the world’s most expensive to insure at about 1,400 basis points for five years and more than 2,000 basis points for one year. Swaps on Norway are the world’s least expensive at 17 basis points for five years and 5.5 basis points for one year.

A basis point on a credit-default swap protecting 10 million euros ($14.2 million) of debt from default for five years is equivalent to 1,000 euros a year. Swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a borrower fail to adhere to its debt agreements.

Debt Limit

The federal government is at an impasse over whether to increase taxes or cut spending as conditions for passing legislation to raise the statutory debt limit.

An election in western New York this week underscored the divide, with Democrats claiming their victory was a clear sign of public opposition to the Republican plan to privatize Medicare. The race was watched for its implications for national politics, including the 2012 presidential race and House Republicans are now vowing to prevent that election from becoming a referendum on the proposal.

“Those in the know will read these elections as further proof the U.S. is miles away from agreeing on how to bring its fiscal deficit down before it’s too late,” Grodzki said. “With every month going by without material deficit cuts the debt burden and the share of tax revenues spent on interest payments keep rising.”

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