Unexpectedly Intriguing!
August 10, 2011

Did the S&P 500's downgrade of the U.S. government's credit rating change how investors view the risk of default in the United States? Better still, what events during the past several years coincide with changes in the risk of the U.S. government defaulting on the debt it issues?

We can answer these questions by seeing how the spreads of Credit Default Swaps (CDS) - the special insurance policies that investors in debt securities can buy that pay out in the event the borrower defaults on their owed debts, have changed over time. Because the costs (or spreads) of these insurance policies are dependent upon the likelihood of default, we can correlate changes in their level over time with the events that could drive the observed changes.

The chart below shows the risk of the U.S. defaulting on its 10-Year Treasury as measured by CDS spreads from 14 December 2007 through 8 August 2011, an interactive version of which is available from Bloomberg:

Bloomberg U.S. 10 Year Treasury CDS Spreads, 14 December 2007 through 8 August 2011

We'll next go through the major gyrations shown in the chart above, providing a timeline of the major events that could influence the perception of the risk of a U.S. default from the end of 2007 through the aftermath of S&P's credit rating downgrade of the creditworthiness of the U.S. government.

Significant Events Coinciding with Changes in U.S. Default Risk
Starting Date Ending Date CDS Direction: Range Milestone
Before 22 Feb 2008 Flat: 6-10 Typical Level of U.S. Credit Default Swap (CDS) Spreads (aka "default risk") in "Pre-Financial Crisis" Period
22 Feb 2008 1 May 2008 Increase: 11-18 Subprime Lending Crisis begins as banks act to bail out bond insurer Ambac. Bear Sterns collapses and is acquired for pennies on the dollar by JPMorgan.
1 May 2008 8 Jul 2008 Decline, Flat: 6-9 Post-Subprime Crisis spike returns to typical pre-crisis CDS spreads.
8 Jul 2008 5 Sep 2008 Increase: 9-16 IndyMac bank fails. Fannie Mae and Freddie Mac (both government-supported enterprises) both increasingly seen at risk. Both are seized by federal government on 7 September 2008.
5 Sep 2008 24 Feb 2009 Increase: 16-100 U.S. Financial System Crisis explodes. CDS Spreads peak at 100 on 24 February 2009.
24 Feb 2009 30 Oct 2009 Decline: 100-21 First phase of financial system crisis abates. U.S. Treasury issues "Next Phase" report in September 2009, which anticipates how emergency financial support from the federal government to the financial industry will wind down.
30 Oct 2009 8 Feb 2010 Increase: 22-47 Second phase of financial system crisis begins with failure of Citigroup, which declares bankruptcy on 1 November 2009. The move forces U.S. government to write off $2.3 billion in TARP bailout money.
8 Feb 2010 16 Mar 2010 Decline: 47-31 Secondary U.S. financial system crisis abates. Federal Reserve begins to unwind emergency measures.
16 Mar 2010 4 Aug 2010 Increase: 31-43 U.S. default risk increases as U.S. new government debt issues continue to flood the markets in record quantities, with debt buyers beginning to balk at amount of U.S. Treasuries being issued to support government spending, as U.S. Congress controlled by Democratic Party declines to pass budget for federal government.
4 Aug 2010 12 Oct 2010 Increase: 39-50 A second step upward in U.S. default risk as concerns begin to grow as U.S. nears national debt ceiling with no action being taken by U.S. Congress, which is fully controlled by Democratic party.
12 Oct 2010 14 Jan 2011 Decrease: 44-36 Likelihood of Republican party winning U.S. Congress pushes default risk downward, as "Tea Party" candidate campaigns focusing on reducing excessive government spending prove popular. After dipping to low of 36 ahead of 2010 election, default risk rises slightly as Democratic party retains control of U.S. Senate, limiting potential for bringing federal spending into control.
14 Jan 2011 31 Jan 2011 Increase: 48-52 Short term spike as President Obama releases Fiscal Year 2012 budget, demonstrating intent to continue and increase excessive levels of government spending, with no plan to reduce it through remainder of his first term.
31 Jan 2011 6 Apr 2011 Decrease: 52-36 Decline in default risk as Republican party controlled House of Representatives passes a budget blueprint developed by new House budget committee chairman Representative Paul Ryan designed to bring federal spending back under control and sets to work on creating budget legislation based upon it.
6 Apr 2011 18 Apr 2011 Increase: 36-50 Spike in U.S. default risk as President Obama sketches out a "second" budget in national speech on 13 April 2011, which continues excessive levels of government spending while also seeking to reduce annual budget deficit by increasing taxes that are unlikely to be supported by Republican-controlled House of Representatives.
18 Apr 2011 17 May 2011 Decrease: 50-41 Decline in default risk as "Ryan" deficit reduction plan passes U.S. House of Representatives.
17 May 2011 1 Jun 2011 Increase: 41-51 U.S. Senate rejects "Ryan Plan" without developing any alternative of its own. U.S. reaches $14.3 trillion debt limit.
1 Jun 2011 13 Jul 2011 Flat: 50-54 Range of volatility in CDS spreads while deficit reduction/national debt limit increase negotiations are ongoing.
13 Jul 2011 18 Jul 2011 Increase: 50-56 Short term spike in default risk as President Obama storms out of national debt limit negotiations.
18 Jul 2011 22 Jul 2011 Decrease: 56-53 Obama returns to the table in secret negotiations at the White House to resume debt limit talks.
22 Jul 2011 28 Jul 2011 Increase: 53-64 Short term spike as Speaker John Boehner withdraws from national debt limit talks in face of Obama/Senate Democrats refusal to consider any spending cuts, insisting instead upon imposing massive tax hikes and continuing unsustainable levels of spending.
28 Jul 2011 2 Aug 2011 Decrease: 64-54 Boehner offers new scaled-back deficit reduction/higher national debt limit plan, which passes the U.S. House on 29 July 2011. Two part spending reduction plan reduces immediate risk of default, which results in lowering CDS spreads to pre-spike level. Deficit reduction/national debt limit increase plan signed into law by President Obama on 2 August 2011.
2 Aug 2011 8 Aug 2011 Flat: 54-57 U.S. default risk, as measured by 10 Year Treasury CDS spreads essentially holds level within a narrow band of volatility, even though S&P issues downgrade to rating of U.S. debt from AAA to AA+ on 5 August 2011. Downgrade has very little no effect on U.S. default risk (debt ratings only *confirm* status of U.S. financial situation - they don't actually change it!)

From the end of 2007 through 8 August 2011, the risk of the U.S. government defaulting on its debt payments, as measured by CDS spreads, in the U.S. increased by about 50 points.

Because the risk of default is directly proportional to interest rates, with a 100 point change being roughly equal to a change in interest rates of 1%, we estimate that the yield on the U.S. 10-Year Treasury has risen to be about 0.5% higher than it would otherwise be if not for the high debt-level driven increase in the risk of a U.S. government default on its debt payments.

Though small, that 0.5% increase is sufficient to reduce the U.S. GDP growth rate by approximately 1.3 to 1.4% in 2011. This is a principal reason why the government's stimulus programs in recent years have largely failed to generate the levels of growth their proponents had projected.

As a final note, we'll observe that actions consistent with the objectives of so-called "Tea Party" have tended to decrease the risk of a U.S. government default over the past several months and years, which directly contradicts the political spin being produced by the White House and Democratic Party members.

By contrast, we estimate that actions taken by either President Obama or his party beginning just in the past year's national debt limit debate have added approximately 10 points to the U.S.' 10-Year Treasury CDS spread, corresponding to a 0.1% increase in the 10-Year Treasury yield above what it would otherwise be. That 0.1% increase in the 10-Year Treasury yield then translates into a GDP growth rate that's 0.2%-0.3% slower than it would otherwise be.

If only President Obama had any good ideas on how to fix that problem....


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