Credit Default Swap: Buying Insurance Against Default in Your Bonds

Hey how about that new iPad? Now everyone can spend more time than ever talking to people through Facebook instead of actually talking to people face to face. What is technology doing to us? We have more ways to communciate than ever but seeming to be saying less and less of substance. Oh well. It is pretty cool looking.

But on to financial markets. The not-so-big news from Wall Street is that the Fed will not be raising the price of money anytime soon. The kingpin of the banker's cartel told the market it would keep short-term interest rates "exceptionally low" for "an extended period of time."

Stocks gave a muted "woo hoo" and rallied about 40 points on the Dow. The rally was weak because low rates for most of this year mean several things, most of which are bad. For one, the Fed isn't sold on the recovery story. It thinks the economy needs cheaper credit to build more momentum.

Secondly, higher short-term U.S. rates would push up ten-year rates. That, in turn would push up mortgage rates. And that, in turn (coupled with falling home prices) would be a death blow to the millions of Americans hanging on to their homes by the skin of their teeth.

That's not what the Fed said, of course. It actually reiterated its intention to stop purchasing mortgage backed securities in March. So far, the Fed has pumped nearly $1.25 trillion into the market to keep lenders to lending to all those first home buyers taking advantage of the tax credit from Congress.

In any event, today's news was mostly a non-event. There was finally some dissent on the rate policy from Kansas City Fed President Thomas Hoenig. He reckons the Fed has been too lax already and the economy doesn't need low rates. But for the most part, the Fed is still intent on financing America's debt recovery program with more debt.

Should we talk housing for a moment? How can we not? In the U.S., new home sales fell 7.6% in December after falling 11.3% the month before. All that government tax tinkering is increasing volatility in home sales. But that's what happens when you alter incentives willy nilly.

The U.S. Commerce Department said 374,000 new homes were sold in December. That was the lowest monthly total since the Department began keeping figures in 1963. What's more, new home prices fell 3.6% to a miserly $221,300. Granted, that's more expensive than the median price for an existing home. But heck...it's starting to look affordable to buy a house in America again...if you can get a mortgage.

In Australia, we can't say the same thing. Prices are soaring in Australia's capital cities, according to data realised by the Australian Bureau of Statistics. Melbourne led the pack with an 18.5% increase in 2009. Hobart clocked in with a 14.4% increase, while Darwin was next at 13.5%, Sydney at 12.1%, Canberra at 10.6%, Perth at 8.7%, Brisbane at 7.7%, and Adelaide at 2.4%.

As a contrarian, Adelaide interests us the most. We were just down there over the weekend. There are some lovely old homes. Sure, it's a bit quiet. And the median price of $427,109 is not cheap. But it's not cheap anywhere in Australia at the moment. The national median price for the December quarter is $525,524 - up 12.1% for the year.

That's insane.

While Australians march down the path of a national house price obsession/mania, the world's bond traders are firing warning shots. Bloomberg reports that, "Credit default swap (CDS) protection buying against sovereign debt default has spiked to five times the level of similar protection bought for corporate bonds, as the potential for a wave of sovereign debt defaults intensifies."

A credit default swap is way of buying insurance against a default in your bonds. AIG, for example, got into big trouble (along with Tim Geithner) for selling insurance on sub-prime backed bonds purchased by Goldman Sachs and other investment banks. When the underlying collateral (U.S. homes) went bad, the bonds fell and the insurance kicked in, taking AIG (and nearly the U.S. financial sector) with it.

Bloomberg's story shows that credit default swaps have jumped for 54 sovereign governments since October by an average of 14.2%. In Europe its worth, with Portugal's CDS rates rising 23%, Spain's by 16%, and Greece's by 5%. But what does it mean?

Well it means traders think we're right. Well, that is, it means 2010 is the year the GFC becomes a sovereign debt crisis. National governments were able to backstop their respective financial systems by greatly expending debt-to-GDP levels. But in some cases, those levels are so high that bond traders rightly wonder if those governments can make good on their debts and still function.

The fact that CDS spread are rising means traders reckon government finances in some nations (especially those in Europe that have no independent fiscal policy, i.e. the means of printing money to pay the bills) are in for a tough year. But then, it's going to be a tough decade for the nation state.

The nation state itself is a relatively modern organisation. It's a way of allocating power (the monopoly on violence). And, when it's consensual, it's way for free people to guarantee that certain rights and liberties (that existed prior to government) are protected in an organised fashion.

But at some point - and we reckon it was the evolution in British finance in the 17th century - the funding model of the nation state turned a way of securing property and individual liberties into a way of making perpetual war. The nation state became the Warfare/Welfare state through the invention of perpetual debt financed by customs, excise, and income taxes.

And here we are in the globalised, iPadded world of today, where the funding model of the nation state is breaking down. It's not able to deliver prosperity. And in some cases it can't even deliver security. So what can it do? It can project power and coerce tribute from its citizens through taxation.

Of course some States are better than others. And we reckon that question - where is the most secure place for myself and my assets - is the most important investment question this year. Not whether house prices and interest rates are going to keep rising.

Dan Denning
for The Daily Reckoning Australia

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