Potential Counterparty Risk By: Gabriel PotterMBA, AIFA® 2016.05.11

During an interview with CNBC last week, presumptive presidential nominee Donald Trump suggested altering the payback terms on the United States debt (i.e. reneging on debt obligations to creditors) as a way to offset an ongoing economic slump in the US.  Noticing the outcry from economists, he then clarified this suggestion yesterday assuring investors and global creditors that US debt terms were “absolutely sacred” and that he wouldn’t try this path.  Instead, he is now considering having the government print money to buy back discounted Treasury notes as a way to alleviate US debt maintenance burden. 

This sort of monetary manipulation is atypical for most presidential nominees and it has made us reconsider counterparty risk.  Generally, counterparty risk is regarded as an abstract, vague, rare, and non-imminent threat.   Certainly, it has a real world history and we have previously considered counterparty risk in very real historical examples.  For instance, in our February 2013 Article – Portfolio Risk-Part 2, we noted the very real counterparty risk as it applies to simple frauds, like Bernie Madoff.  However, that example, while clear, is more of the exception, not the rule.  It is more likely for counterparty risk to come up as an unintended threat from a historically credible institution which has accidentally overextended itself into potential fiscal insolvency, temporary or otherwise. 

I hope a few of you took my endorsement of “The Big Short” since I referred to it a few weeks ago (The Big Shortcoming), because I suspect I may continue to come back to the movie as a point of reference.  In the movie, they made a large point about the ability of the banks to pay off the “shorters” of the mortgage backed securities system if the whole system failed.  The shorters extracted assurance (and insurance) from the financial giants specifically to offset the counter-party risk, which turned out to be both necessary and lucrative.  While their monetary and fiscal policy positions are still in flux and (technically) the candidates are still only presumptive, it may be premature to insist on counter party risk insurance for key investment classes, but this will be a new area of vigilance which we had not been previously monitoring.

Gabriel Potter

Gabriel is a Senior Investment Research Associate at Westminster Consulting, where he is responsible for designing strategic asset allocations and conducts proprietary market research.

An avid writer, Gabriel manages the firm’s blog and has been published in the Journal of Compensation and Benefits,...

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