Betting Against the (U.S.) House

Sometime before Tuesday, Aug. 2, the U.S. government has to decide whether it wants the United States to maintain its standing as the bedrock of the global economy, or pull what amounts to the largest dine and dash in history. After weeks of deadlock, the U.S. House of Representatives passed 11th hour legislation on Friday evening to raise the federal government’s $14.3 trillion debt ceiling that also met House Republican demands for steep budget cuts and no new taxes. But the Democratic-controlled Senate almost immediately voted to set aside the House plan — and without some agreement soon between Congress and the White House, the United States risks the mother of all defaults.

That’s the bad news. The good news is that we live in the 21st-century global marketplace — and if it was possible to make a cool $800 million betting on the housing crash that produced the 2008 economic crisis, surely someone can turn a profit on an ailing superpower’s inability to pay off its loans, right? So where do you start?

First, take a deep breath. An actual default would be an epic disaster — but it’s enormously unlikely, even if Congress technically hasn’t reached a deal. As Slate‘s Annie Lowrey notes, several deeply unpleasant scenarios are plausible, but none involve the United States tearing up its IOUs. The stakes are simply too big.

Nevertheless, Washington may have already administered a remarkable self-inflicted wound to the United States’ financial standing. The chances of at least one if not more of the ratings agencies downgrading American debt are now quite good. And in fact, congressional Republicans’ handling of the debt ceiling — a procedural matter that had occurred without much incident more than 70 times in previous years — has so alarmed Wall Street that an actual downgrade is almost beside the point: The markets’ faith in the U.S. government’s ability to take care of its business has already been badly shaken, and they are already behaving as if U.S. Treasuries are damaged goods. "In our view," J.P. Morgan’s North American equity research department wrote in a note to investors on July 29, "the ultimate legacy from U.S. debt ceiling and sovereign Europe [debt crises] is a loss of credibility of policy makers as voters lose faith in governments to protect them." As if to drive the point home, markets closed on Friday with the Dow Jones industrial average posting the year’s biggest weekly decline. Wall Street eminences are already treating the downgrade as a fait accompli.

The most obvious manifestation of this crisis of confidence, and one on which large sums of money are already being wagered, is in the market for credit-default swaps (CDS). A CDS is essentially an insurance policy on debt, priced to indicate the risk of a debtor’s defaulting. Swaps are available on a variety of corporate and sovereign debts and with varying periods of protection; one- and five-year contracts are common.

The good news for the United States is that the country isn’t close to being Greece yet — a five-year CDS on U.S. debt is currently at its highest price since the economic abyss of early 2009, but it’s less than one-fortieth the price that a comparable swap on Greek debt reached earlier this month. But those U.S. swaps are exploding in value — a one-year CDS is now worth more than double what it was a month ago. And CDS trading on U.S. debt has surged accordingly, up 80 percent in the past month to $250 billion worth of trades a day, according to Bloomberg.

What’s highly unusual is that those one-year swaps are now outpacing the five-year swaps — something that usually only happens in a Greek-grade economic disaster, in which a country runs the real risk of imminent default, debt restructuring, or a similar upheaval — even though the actual price suggests that no one really thinks the United States is headed for default. "It’s very peculiar to see this kind of inversion on this type of credit," says Otis C. Casey, director of research for the financial information services firm Markit. "It’s fairly surreal."

The odd dynamic suggests that though investors are alarmed by America’s flirtation with fiscal self-immolation, they’re not really sure what else to do with their money. U.S. Treasury bills are the textbook definition of a safe haven asset, historically one of the most risk-free assets you can buy next to precious metals. There are other similarly safe investments — German government bonds, for example, or shares of an all-but-invincible blue-chip company like General Electric — but there aren’t nearly enough of them to meet the demands of the global market. And with the European Union in economic turmoil and its governments overleveraged from years of stimulus spending, U.S. debt happens to be in uniquely high demand at precisely its moment of crisis.

One paradoxical result of all this is that one of the investments that benefits from a downgrading of U.S. debt may actually be, well, U.S. debt. The strange-but-not-impossible scenario might go like this: If U.S. obligations were downgraded by ratings agencies, it would in turn force down the overall rating of fixed-income investment portfolios (like pension or mutual funds) that include both stable U.S. Treasuries and an array of lower-rated assets. But since Treasuries are still among the most available highly rated assets, portfolio managers may have no choice but to buy more of them and instead dump other assets with lower ratings (which would likely take a far worse hit in the event of a U.S. downgrade).

But the unassailability of Treasuries points to the biggest problem with a U.S. debt downgrade: It alters one of the great constants of global finance. Markets hate this kind of paradigm-shifting uncertainty, whether it’s positive or negative. "When the norms of the world change so dramatically, it’s never happy," says Jacob W. Doft, CEO of the hedge fund Highline Capital Management. "I think the same thing will happen with a downgrade. Everything we know about how financial markets work will change."

Investors rattled by this sort of uncertainty tend to seek solace in commodities and other surer bets. "When the world’s largest economy is making you queasy, you go to gold, you go to the Swiss franc, you go to China," says Ian Bremmer, president of Eurasia Group, a political risk consultancy. "You hedge." Indeed, as of Friday, gold was trading at a record high on the New York Mercantile Exchange, and the dollar was at a record low against the Swiss franc. "Until we get ink on the deal it’s very irrational for anyone not to buy gold going into the weekend," market strategist Adam Klopfenstein told the Wall Street Journal.

But buying gold and betting on default swaps won’t protect you from the fact that no one really has any idea what happens next. The 500-pound panda in the room is China, by far ther largest holder the largest foreign holder of U.S. debt. "The question isn’t how Standard & Poor’s responds — it’s how China responds," Bremmer says. Chinese finance officials’ remarks have been limited and uncontroversial throughout the debt ceiling debacle, with good reason: Any hint of nervousness out of the country’s central bank would ripple immediately through global markets.