FORTUNE -- A lot of people have noted that at least up until this week, investors have largely shrugged off the possibility of a government shutdown or default.
But that's not entirely true. There is one market where investors seem to be freaking out about the latest budget standoffs in Washington -- the market for protection on government debt.
If you are familiar with the financial crisis, as I am sure you are, then you probably have heard of credit default swaps, or CDS. These contracts are essentially insurance against the possibility of a bond default. But unlike most insurance, the contracts are traded and priced daily. John Paulson bought CDS contracts against subprime mortgage bonds and cashed in billions when borrowers couldn't pay back their home loans.
Like other bonds, there are CDS contracts that are traded for government bonds too. And the price of those have soared recently, up 475% in the past two weeks alone. It now costs $46,570 to insure $10 million of U.S. bonds against default for one year, up from just over $8,000 in mid-September, according to Markit, a research and index firm that tracks derivative prices. So does that mean there is a Paulson-like Big Short on against Uncle Sam?
First of all, the market for credit default swaps is not that big. Back in 2011, when we were close to another debt ceiling potential default, prices of CDS on government bonds soared, and only about $250 million in notion value -- that's the amount you are insuring against (25 of those $10 million contracts) -- was being bought and sold each day. That means you could have bought all the contracts sold each day for less than $1 million. That's not a lot to control a market. So it doesn't take a lot of money to push up prices. That's not to say the market is being manipulated. The point is it doesn't take a lot to push up prices.
Second, the market is weird, starting with the fact that CDS are generally priced in euros. (I converted the prices above.) The idea is that if the U.S. government were to run out of money, the U.S. dollar would essentially be worthless, or worth a lot less, so who would want to be paid in dollars? But if the dollar drops in price enough, who is going to be able to buy the euros to be able to pay the claims on the CDS contracts they sold?
CDS contracts against U.S. government debt are essentially insurance against doomsday, and if doomsday comes, who's going to be around or solvent enough to make good on the contracts? In most scenarios, buyers won't collect. The one scenario, though, where it might make sense is a debt ceiling default where the government does have the money to make its debt payments, but has to stop paying its bills because of a debt ceiling standoff in Washington. Technically, all it takes is three days for the government to miss payments and CDS holders can collect. That's the middle-of-the-road scenario Matt Levine at Bloomberg is going with to explain the spike in prices of U.S. government CDS.
But the International Swaps and Derivatives Association, the ruling body that determines when CDS are paid, has changed the rules on the fly before. Greece was ruled not a default, even though bond holders were forced to take less than they had lent out. So it's possible they would bend the definition of default if the U.S. government didn't want to be seen as a deadbeat. What's more, if everybody thought U.S. bonds would eventually get paid, then they probably won't drop in value much, and there would still be no real value to having he CDS contracts.
Here's another reason why CDS on government debt might be going up: Nervous stock market investors. Stocks are the one market that does tend to react to worries about the government's debt. The Dow Jones Industrial Average (INDU) lost 635 points the Monday after Standard & Poor's downgraded the U.S.'s debt. Bond prices actually rose. The issue is there's not really a good way to insure against a stock market drop. There's no CDS for stocks. You could hedge your portfolio by taking out a short equal to some portion of your portfolio. But then you are giving up a large chunk of your returns if the market keeps on going up, which is what has been happening recently, and why pretty much every hedge fund is sucking wind this year.
Another thing you could do is just get out of the stock market. But that's been a bad trade recently as well. With the stock market up 16.9%, getting out of stocks for a month, which is about how long you would have to get out to sit on the sidelines through the debt ceiling fight, would cost you about 1.4 percentage points.
It turns out that buying CDS contracts is one of the cheapest ways to insure a large stock market portfolio against a potential default. Do it that way and it costs roughly $2.3 million to insure a $500 million stock portfolio. That might sound like a lot of money. But if that portfolio goes up 1%, you made $5 million, twice as much as you paid to insure the whole portfolio against a government default.
The strategy isn't foolproof because these markets don't always move together. But you don't have to collect on the CDS. You just need them go up so you can sell at a profit. Stocks aren't going to go to zero, just down. And anyway, the correlations are good enough for most traders' models, which are still pretty much blind to black swans.
So why haven't investors sold off stocks in anticipation of the government shutdown and debt default trigger? One answer: Wall Street is smarter than that, they are buying CDS contracts. But, of course, that would make the Dow and S&P 500 (SPX) pretty worthless indicators of how likely a government default is, or how damaging it could be. Nonetheless, that probably won't stop some lawmakers from saying, "Hey, if Wall Street isn't scared about a default, why should I be?" All this leads to a really poor outcome for nearly everyone, except perhaps holders of CDS contracts.
A Berkeley professor finds out just how much a certain type of high frequency trading costs the average investor.
By Rob Curran
FORTUNE -- Two recent studies of latency arbitrage suggest the stock-market structure needs a remodel if it's ever going to stop billions of dollars going from unwitting investors into the pockets of high-speed trading firms.
"Latency" refers to the time it takes for a stock quote to get from an MOREAug 30, 2013 8:31 AM ET
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