A U.S. default seen as unprecedented catastrophe

Effect would dwarf Lehman

Insufficient Funds

Labeled technical or not, a default is still a default, said Jim Grant, founder of Grant’s Interest Rate Observer.

“People have typically turned to Treasuries as a safe haven, but what will happen when they realize it’s not safe anymore,” said Grant, who has followed interest rates since the 1970s. “Financial markets are all confidence-based. If that confidence is shaken, you have disaster.”

Treasury Secretary Jacob J. Lew has said the government will have only $30 billion of cash left by Oct. 17 to meet its commitments. Those can run as high as $60 billion a day, which means the Treasury will need to borrow more to meet its liabilities, Lew said.

The Treasury has $120 billion of short-term bonds coming due on Oct. 17, according to data compiled by Bloomberg. An additional $93 billion of bills are due on Oct. 24. On the last day of the month, $150 billion needs to be paid back, including two-year and five-year notes that mature. The total due from Oct. 17 through Nov. 7 is $417 billion.

Ratings Downgrade

While some expect a 2013 default will drive up yields only on Treasury securities coming due, others including former Deputy Treasury Secretary Roger Altman see a wider impact in bond yields, pushing up borrowing costs.

“That would be higher interest costs over some considerable period of time for the U.S. and for U.S. taxpayers,” said Altman, who’s chairman of New York-based investment bank Evercore Partners Inc.

Some point to Standard & Poor’s 2011 downgrade of the U.S. credit rating, which led to an increase in Treasury prices, not a drop. Even after the rating was lowered by one level to AA+ from AAA, investors continued buying U.S. government bonds as they flocked to safety, according to Joe Davis, chief economist at Vanguard Group Inc.

A downgrade to default rating would be different, said Peter Tchir, founder of New York-based TF Market Advisors. Investors, structured vehicles, collateral agreements, derivatives contracts and other trading covenants have ratings- based rules that could force the replacement of Treasuries in a trade or portfolio, he said.

‘Create Chaos’

“Once the system starts to break down related to settlement and payments, then liquidity disappears, as we saw after Lehman,” Tchir said. “Perhaps the things we’re worried about now will be fine after a U.S. default, but who knows what others will not be.”

Treasuries are among the most popular forms of collateral pledged at derivatives clearinghouses, including the one owned by CME Group Inc., the world’s largest futures market. Government agencies such as Freddie Mac and Fannie Mae, which use interest-rate swaps and derivatives to hedge mortgage portfolios, would be affected by a downgrade because it could lower their counterparty ratings and result in more collateral being demanded by trading partners.

“We can’t even imagine all the things that might happen, just like Henry Paulson couldn’t imagine all the bad things that might happen if he let Lehman go down,” said Bill Isaac, chairman of Cincinnati-based Fifth Third Bancorp and a former chairman of the Federal Deposit Insurance Corp., referring to the former U.S. Treasury secretary. “It would create chaos in financial markets.”

Capital Shortfalls

Higher borrowing costs could slow the housing recovery. If 30-year mortgage rates climbed to 6.5 percent from 4.5 percent, a borrower who can now afford the monthly payment on a $200,000 loan would only be able to take on about $160,000 of debt when buying a property, forcing down sale prices.

It would be “bad -- both for affordability and for consumer confidence,” said Jed Kolko, chief economist for Trulia Inc., an online property-listing service.

Banks would have to write down securities on their books that are losing value and face capital shortfalls, according to MIT’s Johnson.

“The government wouldn’t have the cash to rescue the banks this time either,” Johnson said.

China, Japan

About half of the U.S. debt is held by foreign governments, central banks and other overseas investors, according to Treasury data. A default would throw those holdings into question as well as the dollar’s status as the world’s reserve currency, Johnson said. During the 2011 debt-ceiling scare, foreign investors shunned Treasury auctions for about three months, according to data compiled by JPMorgan.

China is the largest holder of U.S. Treasuries, with $1.3 trillion in July, according to Treasury data. Japan follows with $1.1 trillion.

Even if Treasury prices aren’t affected by a default, the damage in other markets could be devastating. U.S. stocks fell 7 percent in one day when Congress rejected the government’s bank- rescue package in 2008, before passing it a few days later.

‘Flying Blind’

The market shocks would be enough to tip the U.S. back into recession and drag the world economy down, according to Desmond Lachman, a fellow at the Washington-based American Enterprise Institute. The event could prove to be the trigger that reverses a weak and fragile recovery, said William Cunningham, head of credit portfolios for the investment arm of Columbus, Ohio-based Nationwide Mutual Insurance Co. Lehman’s collapse was a similar spark, he said.

“Is this the straw among other things that tips an economy without drivers of growth back down into a negative spiral?” Cunningham said.

While a short-lived default might be fixed without major damage to the global economy, drawing a line between short and long isn’t easy, according to Evercore’s Altman.

“If you missed an interest payment by two hours, the markets might look entirely beyond that and forgive you,” Altman said. “If you miss an interest payment by two days, four days, six days, that’s a different story. It’s very difficult to be scientific about this.”

During the final days of Lehman Brothers, Wall Street firms set up war rooms to chart the potential impact of the firm’s demise and prepare strategies to cope with the consequences. Their scenarios, which focused on credit-default swaps, didn’t forecast the contagion that quickly spread after the bankruptcy.

Now, some banks are preparing contingency plans for a possible U.S. default, such as stocking retail branches with more cash, the New York Times reported last week. Those preparations might prove useless once again.

“Nobody knows what would happen if there were a default because the reality is there’s never been even a technical default in the U.S.,” said Russ Koesterich, chief investment strategist at BlackRock Inc., the world’s largest asset manager. “Everyone’s flying blind.”


<< Page 2 of 2

Copyright 2014 Bloomberg. All rights reserved. This material may not be published, broadcast, rewritten, or redistributed.

comments powered by Disqus
Check out Futures Magazine - Polls on LockerDome on LockerDome