Treasury Securities and the U.S. Soverign Credit Default Swap Market [August 15, 2011]   [open pdf - 534KB]

"Paying the public debt is a central constitutional responsibility of Congress (Article I, Section 8). U.S. Treasury securities, which represent nearly all federal debt, have long been considered riskfree assets. The size of federal deficits and the projected imbalance between federal revenues and outlays, however, have raised concerns among some, including the rating agency Standard & Poor's (S&P), which downgraded the U.S. sovereign credit rating from AAA to AA+ on August 5, 2011. S&P also cited 'political brinksmanship' in debt ceiling negotiations as a factor, which raised the issue of a hypothetical federal default. Prices for Treasuries suggest that financial markets continue to consider federal debt instruments a safe haven despite the S&P downgrade. Continued concerns about rising federal debt and the ability of policymakers to reach solutions to fiscal challenges could raise borrowing costs and negatively affect capital markets. A credit default swap (CDS) contract is a way to hedge or speculate on credit risk, including sovereign credit risk. A CDS protection buyer, in exchange for an annual fee set by the market and paid quarterly, can trade an asset issued by a 'reference entity' (or a cash equivalent) for its face value if a 'credit event' occurs. A CDS buyer need not own or borrow an asset issued by the reference entity, thus may hold a 'naked CDS.' A committee of the derivatives trade organization, the International Swaps and Derivatives Association (ISDA), determines whether a credit event has occurred, according to their interpretation of applicable guidelines. In general, failure to make a timely payment usually constitutes a credit event, as does a repudiation of debts, and in some cases, debt restructuring."

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CRS Report for Congress, R41932
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