Tuesday, January 15, 2013

Are Credit Default Swaps on US Debt Constitutional?

A credit default swap (CDS) is insurance on a fixed income security. If the underlying asset defaulted, then the party that purchased the CDS is paid the par value of the security. If one purchases a CDS, that person is assuming there is a risk that the security will not be paid in full. In effect one is "questioning" the credit worthiness of the asset.

Which brings us to the 14th amendment. In section 4 it states: "The validity of the public debt of the United States .... shall not be questioned". So, are CDS' constitutional when the underlying asset is a US bond?

Maybe its constitutional to sell a CDS on US bonds (since a seller can argue they thought there was no risk ie. not questioning the validity). But the buyer is implicitly assuming there is a risk.

Will this technicality ever matter? Probably not. The odds of the US defaulting seems small. And if we did default I think we'd be more worried about other things. Either way, I'm glad to live in a country where I'm allowed to question. 

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