Is the Market Mispricing the Risk of Default?

Photograph by Petra Patitucci

Markets are betting no one will jump off. A frightening wager, no?

After Tuesday aftternoon’s generally bad signals on the progress of budget talks (even before the meltdown in negotiations after U.S. markets closed for the day), it’s hard not to ask: Do the markets care? The news from Washington seems worse, and still there is only minimal impact on the U.S. stock market.

This feels like a classic case of the mispricing of catastrophic edge cases. To be clear: The chance of a U.S. default is small. It is far more likely that there will be a deal, or a jerry-rigged temporary deal, and the U.S. will pay its debts. The markets seem to be pricing the risks of a catastrophe–whether a default, a disordered effort to cut government payments at the last minute, or a full-blown Consitutional crisis–as essentially zero.

It’s clearly not zero. How great is the chance of one of those events? There’s really no meaningful way to settle on a single number. In general, though, it has turned out over the years that this kind of catastrophic tail risk is greater than most market participants assume. It’s worth checking out this short white paper from Pimco on “fat tails,” which lists ten catastrophic events over the last thirty years that caught world markets by surprise.

In theory, it should be possible to hedge this kind of tail risk with derivatives, buying protection for the worst case scenario. In practice, it’s unwieldy or impossible for small investors and expensive for bigger ones. (And in the worst-of-the-worst-case scenarios, there’s risk that the counterparties who sold you protection could go under.) That leaves the vast majority of investors crossing their fingers and hoping to ride out the storm.

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