The Story Of Risk: And the illusion of the Federal Reserve's power to forever control rates.

• Author: Brenner, Reuven

An insurance company offers catastrophic insurance against a volcano erupting--but the company's assets are all on the slope of that same volcano. So if you bought credit default swap protection on such bonds from this insurance company, it would not pay out the value of the "insured" bond for people having escaped the flowing lava.

I am giving this extreme example because it sheds light on the fact that headlines about U.S. debt, deficits, and likelihood of default notwithstanding, Markit's credit default swap prices during November 2021 for insuring $10 million of five-year Treasuries have been hovering at about 14 basis points ($14,000), implying a 0.23 percent probability of default. This price was the ninth cheapest on November 3 in a list of twenty-eight countries--including Germany, Austria, and the United Kingdom--priced between 7.8 and 12.5 basis points. The highest price is for insuring Turkey's bonds at $443,000, implying a 7.39 percent probability of default (as of November 3). All these numbers assume a 40 percent recovery, though what would guarantee this percentage except military invasion or heavy sanctions before countries could ever borrow again on global credit markets is a good question.

Now say you bought this protection on U.S. Treasury bonds, and the United States unexpectedly defaulted. It is unlikely then that companies that sold the insurance would be able to pay--like the case of the insurance company located on the volcano slope. Recall that after the 2008 crisis, the government bailed out financial institutions (including AIG)--in fact bailing out the banks--which now it would no longer be able to do.

If so, what do the prices in the credit default swap market reflect? The numbers below answer not only this question but also shed light on bond and stock prices for the last few years, and also the non-appearance of bond vigilantes, and Fed policies--and what their normalization would imply.

INTEREST RATES: INFLATION AND DEFAULT

Interest rates reflect, among other things, expectations of inflation and default. Over the last year, the ten-year U.S. Treasury bond yielded roughly between 0.8 percent and 1.56 percent (as of November 3). Credit default swap prices allow purchasers to disentangle the risk of default from that of inflation, and allow fund managers to use the information as part of their portfolio management--hoping not to find themselves being the last investors holding the securities when catastrophe...