Relevant Matt Levine: "Why Would Anyone Buy Credit Default Swaps on the U.S.?"
The reason why this is illogical is that there is very little distinction between "the dollar" and US sovereign debt. It applies to all countries in a similar situation, for example "the Yen" and Japanese Government Bonds. It doesn't quite apply to odd cases like, IDK, Spanish sovereign debt in EUR and "the Euro" since the Spanish government does not control all forms of the issuance of the currency of the bond.
What they were doing is identifying pairs of securities whose values had diverged and they believed would eventually converge. They would short the more expensive one and buy the cheap one. When they converged they would sell the no longer cheap one, use the money to close out the no longer expensive one, and collect a profit.
However usually the reason why one was more expensive is that it had a more liquid market. So people could safely invest in it with money that they might need back quickly. This shouldn't matter if you planned to buy and hold though..at least in theory.
But in the wake of the Russian default, liquidity became more valued. So people sought to get rid of illiquid securities and buy liquid ones. This meant that LTCM had shorted things that were rising in value, and bought things that were falling in value. So they had a loss. And as the shorts got higher, they wound up having to sell assets at a loss to cover their shorts. And now the temporary losses became very real ones, and drove them bankrupt.
However, infamously, their investments made money in the end. They just weren't able to last long enough to benefit from it.
While most of their strategy was convergence arbitrage, if I recall from the book, they thought of selling short equity options as a form of selling insurance.
People buy these options to insure against some event and they expected more buyers than sellers, so LTCM figured they would profitably be the provider of it. Well-structured insurance is always a loss to the buyer (they take in more than they pay out).
I was working in the city shortly after LTCM failed and one of the interesting things I heard is that several large European institutions were using LTCM for overnight treasury. So at cob in Europe they would sweep funds into LTCM and then move them out the next morning for trading. If that was actually the case it would have caused massive fluctuations in their assets during the day which would be extremely hard to manage.
While that's true, Spain could go the tax route and say "gimme more euros this year" or sell off assets it owns. I guess a printer is faster (if they feel like it) but medium-term, developed countries have lots of tools to pay down debts (if they feel like it).
For some reason, people are more comfortable with inflation as a tax than taxes.
Because everything doesn't inflate at the same rate at the same time. That means the average person has some theoretical room to reconfigure their spending to minimize the impact of inflation. Ordinary people have no legal options to minimize the impact of higher taxes. That requires expensive CPAs and lawyers.
(Right? What did I miss by not taking Econ 102?)
What the average person forgets is that some people (and businesses) have wayyyyyy more debt, so when it gets diluted, they're a net loser on average.
Kinda like getting a $1000 stimmy cheque while large capital owners gets their equity saved by government bailout money. Everybody wins something, but winning last place isn't a win when no real wealth was created.
Thanks for coming clean.
The true credit risk on US Treasuries is indeed an abstract and mysterious creature. Nobody knows what would such a "default" mean in practice, what paper would get paid up and what paper would not get paid. Would commercial bank deposits at the Fed get paid? And if not, then what does it even mean to "pay in dollars"? Like how do you achieve "paying someone X dollars", do you deliver printed currency?
For example, suppose you’re running a company that has won a government contract and you receive scheduled payments from them. You use the payments to pay your suppliers and employees. If you don’t pay your suppliers and employees on time it causes all kinds of problems.
If the government looks like they might delay their next payment to you, you can “buy insurance” so that you can still make the payments. Is this gambling? Maybe? But if you don’t gamble there are real consequences, so “not playing” is still “gambling”.
It’s not really ludicrous, the US Treasury isn’t selling bonds of every duration every single day. You need some kind of framework to outline which Treasuries are acceptable to settle derivative contracts like futures/options/CDSes since Treasuries are not directly fungible like equity shares or commodities.
In a parallel universe the US has entered a short technical default just slightly before SVB's collapse, which allowed them (if CDS insured) to collect all MBS at par value.
Long treasuries (>1 year) are issued at very close to par and do pay coupons. A treasury that is trading at 50-something cents on the dollar has lost a lot of value (because it has a lower coupon rate than newer treasuries).
.. there are special rules which trigger even in a short default allowing a fair bit of money to be made turning the CDS into a sensible bet on a short duration US default.