Creating A New Derivative: The Market For Sovereign Credit Risk

By Chandrashekar (Chandra) Tamirisa, (On Twitter) @c_tamirisa

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The annual American budget ritual between Pennsylvania Avenue and Capitol Hill is a sight to behold in the politics of imperial economic indiscipline. It is a no holds barred, guard-less rugby with no rules. There are neither budget constraints nor time deadlines. Pay-go acquires a new meaning: keep borrowing as the country needs money because America is the only game in town.

Government departments sit on the edge in anxiety, as furloughed workers wait for their paychecks once the Treasury gets the money to sign-off on the checks after its chief signs-off on the crisp new dollar bills and/or US debt. Neither the Congress nor the President are anxious, for the tug of war is about looking good before the next election day. Government reform is but a circus for the bitter medicine to go down with a spoonful of sweet talk about budget discipline.

United States, to pay as it goes, must pass a law to enable it to pay if its expenditure exceeds its income. The law’s purpose is to remind lawmakers that there is a budget constraint governed by the amount the country can borrow every year a.k.a the debt ceiling. Its politics is to remind them to keep their jobs in a manner that is most expedient. Thanks to the global economic power wielded by the country, the staged political rancor often yields the foregone conclusion of raising the debt ceiling to borrow more.

Why the debate over debt when there is the genius of financial innovation? What applied to Greece can also apply to its modern incarnation on the other side of the Atlantic.

The debt ceiling can always stay where it is. Investment banks the likes of Goldman Sachs can buy debt-servicing rights to current national debt (for example, interest on debt in FY 2012 was $360 billion or about 1/3 trillion), thus getting debt-servicing costs off the Treasury’s books. Goldman, for example, in return pays the Treasury for buying US debt-servicing rights, offsetting US indebtedness. It and others like it, from among the 21 bond trading desks which the Fed does not regulate, get an infusion of fresh cash from the central bank through Fed-purchases of outstanding government bonds, further lowering total US indebtedness, but within the constraints of the Fed’s overall economic context for monetary policy.

The financial institutions service the Treasury IOUs, including social security, healthcare and national defense (about two-thirds of the current annual federal budget), but hedge their failure using a sovereign credit risk swap (SCRS) with another financial institution to which they pay an “insurance premium.” Should the US economy not perform well and the government has to keep selling its national debt-servicing to Wall Street in a similar manner, the Fed bails out the providers of SCRS just as it did AIG.

It would then be in Wall Street’s interest for the long rates not to rise to keep their servicing costs down on the government IOUs by raising real investment in the domestic economy.

When is the next debt ceiling debate?


About Chandrashekar (Chandra) Tamirisa
This entry was posted in Economics, Finance, Fiscal Policy, Monetary Policy, Transformations LLC and tagged , . Bookmark the permalink.

One Response to Creating A New Derivative: The Market For Sovereign Credit Risk

  1. Reblogged this on One World and commented:

    Derivatives can save US economy from the fiscal cliff.

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