Investors bet on a U.S. default

October 3, 2013: 7:50 AM ET
NEW YORK (CNNMoney)

Want to bet against the "full faith and credit" of the United States government?

A few financial institutions are doing just that -- betting the government will default on its debt if Congress can't agree to raise the debt ceiling this month.

If the U.S does default, they could reap a total payout of around $3.4 billion.

Sound like a lot? Actually, investors seem less convinced that a default will occur this time around than they were during the last big debt ceiling scare in the summer of 2011. Back then, they held contracts that would have paid out about $5.6 billion in the event of a default, according to the Depository Trust and Clearing Corporation.

Here's how it works: Financial institutions can buy what essentially amount to insurance contracts that protect against a government default.

These securities, called credit default swaps or CDS, cost a 0.34% premium to insure against the government defaulting in the next year. That means an investor pays about 34 cents for every $100 of potential payout they would receive in the event of default.

Related: Is Wall Street betting against Washington?

But it's not quite that simple.

First, these contracts are only available to institutional investors.

Second, credit default swaps on U.S. debt are usually priced in euros, because if the United States defaults, who wants to be paid back in dollars?

Third, there are far less lucrative payouts if other scenarios occur. For example, the government could elect to partially pay its debt. Even the definition of "default" is murky.

What does it mean to default? The government will soon fall short on cash, and could face a debt ceiling crunch by the middle of October.

The government expects to hit the debt ceiling by October 17, and soon after could fall short on cash and be unable to pay all its bills.

Let's say the government fails to pay daily expenses like its employees' wages, electric bills and Social Security checks. This would not constitute a "default" in the world of CDS, as long as Uncle Sam continues to pay bondholders in the meantime.

In the CDS market, a true "default" happens only if the U.S. were to stop paying principal and interest to Treasury bondholders, or if it refuses to acknowledge its bond contracts or restructure its debt.

This scenario has happened only once before, due to a computer error in 1979. The impact was only temporary and Treasury eventually paid bondholders at a later date. Plus, that was before credit default swaps existed.

This time, investors largely believe the Treasury Department will find a way to avoid a technical default at all costs, even if it means cutting other expenses first.

In the rare event that it does happen though, CDS investors will still have to jump through hoops to collect their money.

It's not easy cashing in: On the first day of default, investors could demand payment from the investment banks that sold them their CDS contracts.

Even then, however, the U.S. would have at least three more days to make up for missed debt payments before banks would have to pay out to CDS holders. (CDS contracts typically have a three-day grace period.)

Related: 8 things you need to know about the debt ceiling

Next, CDS holders would have to file for an official review from the ISDA Determinations Committee to determine whether a credit event has in fact occurred.

That board currently includes some of the world's largest financial firms, like Bank of America (BAC), Goldman Sachs (GS), JPMorgan Chase (JPM) and Deutsche Bank (DB), which don't exactly have an interest in a U.S. default, because they hold massive amounts of U.S. Treasuries and dollar-denominated assets.

Dean Baker, co-director of the Center for Economic and Policy Research compares it to buying insurance to protect against a nuclear bomb. If the bomb goes off, is anyone going to be left to pay out the insurance?

"If we had a default, it's very hard to say what the world looks like in those circumstances. Who do you think will still be standing?" he said. "I think you have a lot of silliness. People buy insurance policies that don't make sense."

Most investors still trust Uncle Sam: Those investors who are betting on a U.S. default are just a miniscule segment of the market.

Only about 886 of these CDS contracts existed as of last week, down from 1,300 contracts held at the end of July 2011. Worth $3.4 billion in insured value, they're a drop in the bucket compared to the nearly $12 trillion (with a T) in outstanding Treasury bonds held by anyone from individual Americans to hedge funds to the Chinese government.

If the U.S. defaults, bond prices are likely to plummet and yields will climb, and these folks will be hung out to dry.

Needless to say, the vast majority of investors still believe the government will stick to its word and pay bondholders.

The risks are quickly rising with each day, though. While it remains a small market, the price to insure against the United States defaulting in the next 12 months has already multiplied by six-fold in just one week.

- Fortune's Stephen Gandel contributed to this report

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