When the Sept. 11 attacks still dominated our thoughts and government was preoccupied with how to defend us against global terrorism, somebody took one good idea, mixed it with another good idea, and came up with … a mess.
Good idea No. 1: The analysts at the Defense Advanced Research Projects Agency were impressed with the forecasting accuracy of the futures markets when people had money at risk in the outcome.
Good idea No. 2: The agency also was developing some new and very sophisticated information systems to detect patterns in global events that would signal changes in the likelihood of terrorism threats.
The two good ideas combined to produce a third idea that was like one of those sad Crayola combinations that looked so great in your kindergarten imagination. The projects agency’s unfortunate creation was called the Policy Analysis Market.
The basic concept was that it would allow investors to make money by correctly guessing world events such as terrorist attacks or a revolution in the Middle East. This was not a good idea.
When word of the market idea became public, there was an immediate and vocal outpouring of political distaste for the concept. It just didn’t seem right for people to be gambling on America’s future by assigning dollar values and Vegaslike odds to other people’s suffering.
In the recent unpleasantness over the U.S. federal debt limit, though, one of the little-discussed elements of the situation was that global traders were already handicapping U.S. Treasuries and wagering on a possible default. They were assigning casino odds to people’s economic suffering.
The gambling mechanism was the market for credit default swaps. These are essentially stripped-down, short-term, mini-insurance policies that have been standardized so that they can be purchased and sold in financial markets. These insurance policies cover government and corporate bonds and pay off if there is a “credit event” — a missed interest payment or a total default. Their cost, or market price, reflects the judgment of investors and financial smarties on the likelihood of a partial or total default.
Credit default swaps have been traded since 1995, but until recently there was no active market for any that covered U.S. Treasury bonds. They were the “risk-free” standard that provided the zero in the risk calculation number system.
The market for U.S. Treasury credit default swaps is small, about $5 billion (net), but the fact that it exists at all is a rebuke to our country’s financial management and seriousness of purpose.
Based on that market’s direction and volatility, most investors, like most Americans, did not take the threat of a default too seriously. However, once the emptiness of the debt-ceiling agreement is recognized we will almost surely see more activity in this market.
The credit default swaps market is not really the same thing as the traditional bond market or the trading of U.S. Treasury futures. These markets generally look to price — that is, the interest rate — as the offset to risk. And the risk of default ranges from near-zero, or “unthinkable,” to “junk bonds” where default is a genuine concern.
The bonds rated AAA pay the lowest interest rates while those issued by troubled firms or governments pay the highest. Bonds issued by Ireland, for example, were recently downgraded to “junk” status, and the Irish government will have to pay very high interest rates to get anyone to buy them.
The big difference between the bond trading markets and the credit default swaps markets is in what happens if the bond issuer defaults. An investor who has purchased one of those bonds is pretty much out of luck. If the investor holds a credit default insurance contract, though, the bond will be paid off by the insurance company.
Clearly the bond markets and the credit default swaps markets are the ones to watch in the aftermath of our recent political taffy pull. The debt ceiling agreement undoubtedly seems like an important achievement to the inside-the-beltway crowd, but financial markets do not necessarily buy into stuff like that.
One of the most disturbing aspects of the discussions that surrounded the debt ceiling debate was the idea that the U.S. government could use defaulting on its obligations as a management tool to be used in service to other goals. The second-most disturbing was the idea that the 14th Amendment could be bent and reshaped to meet the needs of financial, or political, expediency.
Financial markets do not forget these things and they have undoubtedly contributed to making a U.S. default less unthinkable and then simply attaching gambling odds to it. There is no “do-over” in financial credibility and it will take a lot of work and a lot of time to clean up the mess we have made there.
James McCusker is a Bothell economist, educator and consultant. He also writes a monthly column for the Snohomish County Business Journal.
Talk to us
> Give us your news tips.
> Send us a letter to the editor.
> More Herald contact information.
