Derivatives to the Rescue? How ‘Betting Against’ the U.S. Could Prevent A Default Crisis

FROM TIME | JULY 28, 2011

Wednesday’s plunge in the markets signaled that the impasse over the debt ceiling ,if it continues, will eventually trigger a substantial market sell-off. Until now, there had been surprising complacency among investors, who seemed to assume that after all the noise and haggling there would, of course, be a deal. That belief itself should have been a warning sign; when investors dismiss what is known as “tail risk,” only trouble ensues.

But largely overlooked throughout this drama is a robust trade in financial derivatives tied to the results of the debt debate — and those are beginning to tell a story of their own. Unlike in 2008 and 2009, when these shadowy financial instruments almost destroyed the global financial system, derivatives this time may actually fulfill their intended role of reducing risk.

While it is unlikely that the U.S. will default on its debt even if a deal isn’t reached, a few investors have positioned themselves for the worst-case scenario by purchasing some $5 billion worth of credit-default swaps. Credit-default swaps (CDS), which investors buy and sell as insurance against debt defaults, are among the more arcane of the derivatives invented and sold on Wall Street and on financial bourses throughout the world. In fact, few had even heard of them until the fall of 2008, when the huge scale of the CDS market almost brought down AIG and led to the single largest government bailout.

In the grand scheme of market economics, $5 billion is not an especially large number. But it is telling that some on Wall Street are preparing for the worst by purchasing instruments that could yield substantial returns in the event of a default. Others, meanwhile, are protecting themselves by reducing their exposure to equities or positioning themselves “short” against U.S. market indices. And global investors have already profited by taking similar positions on Greek debt, which received yet another rating downgrade on Wednesday.

Many will decry these bets, saying they undermine the ability of Greece and the U.S. to meet their outstanding obligations. These critics will point to the crisis of 2008 and 2009, when hundreds of trillions of unregulated and unregistered derivatives, augmented by substantial leverage, proved to be more than the system could bear at a time of strain and crisis. And no doubt Warren Buffet will be quoted calling derivatives “weapons of financial mass destruction.” Even the scope of the market is troubling: According to ISDA, about the same amount of derivatives — just under $500 trillion worth — are in circulation now as in mid-2008.

However, there are two important distinctions to draw: One, global investors are now far less leveraged than they were; and two, credit standards at banks have tightened substantially.

Unlike Buffet, Robert Schiller of Yale has long argued that derivatives aren’t inherently dangerous, but are more like an awesomely powerful tool. Used well, they mitigate risk; used poorly, they augment it. With less leverage and less speculation in the markets, credit-default swaps and assorted derivatives may be just the ballast needed to keep our economic ship afloat if — unlikely as it is to happen — the U.S. really does default on its debt.