Would the US Really Default?

I for one thought that a US default was outside the range of realistic possibility.  For the last half a century, the United States has been the icon of economic strength and stability.  But it appears that the at least some people think it's a real possibility in the next year.

The chart above shows the price of a 1-year credit default swap on US Treasury Bills.  For those of you who don't understand credit default swaps, a quick primer:

A credit default swap is a an agreement between two parties, typically large institutions.  Retail investors can't (yet) participate in the CDS market.  The agreement is set so that at the end of the period if the underlying debt issuer has defaulted (declared bankruptcy or otherwise defaulted on their debt payments), then the buyer of the swap gets paid $100.  If there is no default, then the swap agreement comes to an end worthless.  At the beginning of the contract, the buyer of the swap pays an agreed upon amount to enter the transaction.  In many ways is is like "insurance" for a bond holder.  If the bond defaults, the CDS is a mechanism to make them whole again.  However, it's not bond specific, so it's not an exact hedge.  This chart says that a CDS on US Government Debt is currently trading at 32bps.  Which is 0.32% or 32 cents for a $100 bond.  While that may not sound like a lot -- we can see that is almost 200% higher than it was last week.

It's important to keep this in perspective.  A 1-year CDS for Greece are currently trading over at 22.37%.  So we aren't even in the same magnitude of numbers.  But that indicates to me that 25% or so what a country might be trading at if it's...insolvent, running a massive deficit, and has only a few months of cash left.  I'm a little surprised it's not higher than that.  The country is on the brink of default!  It must be the tenuous EU and ECB backing that keeps the price of Greek CDSs relatively low.

Regarding the US CDS rate, I wouldn't panic about this move from 10 bps to 32 bps.  However, it is interesting to see SOME possibility of US default being priced into the market.  I suspect that this is mostly an attempt to price in the political risk of the US Congress not raising the debt limit before August.  I honestly can't imagine the havoc in the capital markets if the debt ceiling isn't lifed and the US actually enters a default situation.  I just can't imagine it.  It would be chaos. I'm sure between now and then there will be plenty of people who are smarter than me will paint some pictures in the financial and popular press.  I would expect that the images will be vivid enough to get congress to raise the debt cap.  In either case, I would expect that the US CDS probably get more expensive in coming months with or without a raise in the debt ceiling.

MONKEY BUSINESS:

Holding: AGQ ($159.70)

A Shrinking Inventory of Registered Silver

One of the more interesting pieces of the silver situation is the declining stocks of registered silver in the commodities warehouses around the world.

The prices of commodities on the commodity exchanges refer to the price of delivery of a specific amount of good on a specific date in the future (and at specific terms). For example the price of oil that is so frequently quoted in the news actually refers the price of one barrel of West Texas Crude delivered to the oil refineries in Cushing, Oklahoma. Unlike the stock market, the commodities markets actually have a physical good that is delivered at the end of the day. If you purchase a futures contract and don't sell it before expiration, you will take delivery of "stuff." Commercial users may actually want the coffee beans or corn, but most financial participants will simply take delivery of stuff via accounting entries in shared warehouses. However, sometimes a market participant will take physical delivery and request the product leaves shared warehouse.

For silver, there has been a shrinking supply of registered silver since 2007. "Registered" means that the silver meets all of the specific criteria to be deliverable and is also classified as such so that it can be transferred from one owner to another inside the warehouse (or can leave the warehouse).

The chart above shows the registered silver inventory at the COMEX until April 26, 2011. The most recent report (May 19) shows that the level of registered silver has fallen to 32.2 mm oz. Since silver futures trade in contracts of 5000 oz each, that means that the COMEX warehouse could only fulfill 6437 contracts if they stood for delivery today.

As of yesterday, the COMEX had 121,495 contracts outstanding. There were just a few still open for May and June. However, July shows 62,481 contracts still open. I don't know how many of these contracts will stand for delivery. In any case, using the most recent information, the COMEX would only be able to deliver enough silver to cover 10% of the outstanding contracts for July.

So, what happens if the COMEX doesn't have enough physical silver to meet the delivery requests? I don't know. I would expect it's partially a legal/contracts question and it's partially a market mechanics question.

From a purely theoretical standpoint, the silver market would adjust prices until an equilibrium is reached. Prices would head north until enough sellers decide that they don't really want their silver at the market price. Supply could come from new entrants or from silver owners who have eligible but un-registered silver already stored in the warehouse.

Another possibility is that the COMEX forces people to settle in cash rather than default. This seems like a likely path -- but then opens up the possibility that silver futures prices and physical silver prices diverge. This seems highly problematic for the exchanges and all the market participants. If your silver future doesn't really buy you silver, when what are you buying? This divergence seems to be a popular theme on the internet, but I don't think it's likely. There is too much reputational risk on the line for the exchanges to let this happen.

There are a lot of practicalities at play. It's unclear what will happen, but I expect that we will start to see it happen in the next few months. December has reasonably high level of open interest too. So if July doesn't give us resolution, it's likely that December will.

MONKEY BUSINESS:

Holding: AGQ ($159.70)

A Collapse in Silver

Over the six months, silver was a delight to own. That has changed in dramatic fashion over the last two weeks.

As you can see, the white metal has simply been pummeled since May 1, losing all of the value gained in the month of March in nearly a week.

So the question at hand is whether or not this is a temporary setback, or whether this is the official popping of the commodities bubble.

I believe that the scale of this decline is quite important. They say that sometimes things "take the stairs up and the elevators down." It certainly is the case here, several weeks of gains were wiped out in a single week. However, I think it's important to see that we did not loose a year of gains, but rather a month of gains.

In my opinion, this recent crash was simply the short squeeze from March & April coming to an and in grand fashion. I sold some in the run up, but should have sold more. Hindsight tells me I should have sold all of it, but as always hindsight was nowhere to be seen on May 1st. Thanks for nothing, hindsight.

This dramatic decline was encouraged by some extremely meaningful margin hikes by the CME. Margin requirements were nearly doubled in a week and this forced out a number of investors/speculators who were leveraged to the hilt. If the goal of the hikes was to lower the price, it was hugely effective as margin increase not only pushed out new positions but tripled or quadrupled the size of margin calls for anyone who initiated positions in the second half of April.

There is a lot to the story on silver. I will try and explain what I understand in future posts. But fundamentally, the two most important issues at hand are worldwide currency depreciation and the availability of physical silver.

Silver bounced off $33.00 pretty well this morning. Perhaps a bottom is in.

MONKEY BUSINESS:
Buying AGQ @ $159.70

Step 1

I've wanted to blog for a long time, but wasn't sure that I had the time or the dedication to make something that was worth while. But I figure that the first step is simply to start. If it sticks, it sticks.

The idea behind "The Market Monkey" is use a blog as a venue to share some of the lessons that I've learned an investor, banker, and student. I certainly don't have all the answers, but I've made and lost a few fortunes in the market over the last 20 years. Perhaps I can share some of my lessons with others, and help myself to remember to follow my own advice.

Step 1: Start a blog.