A U.S. default seen as unprecedented catastrophe

Effect would dwarf Lehman

Anyone who remembers the collapse of Lehman Brothers Holdings Inc. little more than five years ago knows what a global financial disaster is. A U.S. government default, just weeks away if Congress fails to raise the debt ceiling as it now threatens to do, will be an economic calamity like none the world has ever seen.

Failure by the world’s largest borrower to pay its debt -- unprecedented in modern history -- will devastate stock markets from Brazil to Zurich, halt a $5 trillion lending mechanism for investors who rely on Treasuries, blow up borrowing costs for billions of people and companies, ravage the dollar and throw the U.S. and world economies into a recession that probably would become a depression. Among the dozens of money managers, economists, bankers, traders and former government officials interviewed for this story, few view a U.S. default as anything but a financial apocalypse.

The $12 trillion of outstanding government debt is 23 times the $517 billion Lehman owed when it filed for bankruptcy on Sept. 15, 2008. As politicians butt heads over raising the debt ceiling, executives from Berkshire Hathaway Inc.’s Warren Buffett to Goldman Sachs Group Inc.’s Lloyd C. Blankfein have warned that going over the edge would be catastrophic.

“If it were to occur -- and it’s a big if -- one would expect a series of legal triggers, potentially transmitting the default to many other markets,” said Mohamed El-Erian, chief executive officer of Pacific Investment Management Co., the world’s largest fixed-income manager. “All this would add to the headwinds facing economic growth. It would also undermine the role of the U.S. in the world economy.”

Lehman Aftermath

The U.S. stock market lost almost half its value in the five months following Lehman’s failure. The country had its worst recession since the Great Depression, taking the global economy down with it. Unemployment surged to 10 percent, the highest in three decades.

Another depression was prevented only by unprecedented action by the Federal Reserve, which pumped $3 trillion into the financialsystem. The U.S. Treasury provided about $300 billion of capital for the nation’s banks.

“If we miss an interest payment, that would blow Lehman out of the water,” said Tim Bitsberger, a former Treasury official under President George W. Bush and now a New York-based managing director at BNP Paribas SA. “Lehman was an isolated company, and now we are talking about the U.S. government.”

Buffett has asked politicians to stop using the debt limit as a weapon in policy debates. Morgan Stanley CEO James Gorman urged employees to contact their congressmen to remind them about the “unacceptable consequences” of a default.

‘Nuclear Bombs’

“It should be like nuclear bombs, basically too horrible to use,” Buffett, 83, said in an interview published by Fortune magazine last week.

One unexpected consequence of Lehman’s collapse was the seizing up of the repurchase agreement, or repo, market -- a form of secured, short-term borrowing used by Wall Street banks and investment firms. Many of Lehman’s trading counterparts discovered the collateral they believed was backing their loans wasn’t there to grab as rules allowed. That scared investors in the rest of the market, closing off other trades and leading to fire sales of securities and further price declines.

A government default could freeze the repo market more than Lehman’s collapse because U.S. debt forms its backbone. At least $2.8 trillion of Treasuries serve as collateral for repo and reverse-repo loans, according to Fed data.

‘Holy Cripes’

In the event of a default, Treasuries might no longer be eligible as collateral for repo agreements, according to James Kochan, Wells Fargo Funds Management LLC’s chief fixed-income strategist. The cheap funding for the holdings lowers the yields demanded on the investments, and unwinding the positions could amplify losses for lenders and borrowers.

If Treasuries were ejected from the market, “Well, holy cripes,” Kochan said in an interview.

In 2011, the last time Congress was gridlocked over the extension of the debt ceiling, repo rates rose as money-market funds pulled back because they didn’t want the risk of holding a security in default.

“A lot of this is about fear of the unknown,” said Scott Skyrm, a former head of repo and money markets for Newedge USA LLC and author of “The Money Noose: Jon Corzine and the Collapse of MF Global.” “There is no upside to being in the market in that environment, so people pull out.”

The U.S. didn’t default on its debt in 2011. Republicans and Democrats reached a last-minute deal to raise the borrowing limit. Even so, the posturing hurt consumer confidence and wiped out $6 trillion of value from global stocks.

Historical Lessons

While none of the people interviewed for this story expect the world’s largest economy to default this time either, most say the chances of it happening now are higher than in the past.

“It would be insane to default, but it’s no longer a zero- percent probability,” said Simon Johnson, a former chief economist of the International Monetary Fund who teaches economics at the Massachusetts Institute of Technology and is a columnist for Bloomberg View.

The U.S. hasn’t defaulted since 1790, when the newly formed nation deferred until 1801 interest obligations on debt it assumed from the states, according to “This Time Is Different,” a history of financial crises by Carmen Reinhart and Kenneth Rogoff.

Technical Default

In 1979, the U.S. was late to make payments on about $122 million of bills, in part because of “severe technical difficulties” that the Treasury said stemmed from a word-processing failure, according to the Financial Review’s August 1989 issue. While payments were made after a short delay, including with interest for tardiness, the hiccup caused yields to rise by half a percentage point and stay there for months.

A default today could be deemed “technical” because it would be the result of the government’s unwillingness to pay, not its ability, JPMorgan Chase & Co. analysts including Alex Roever said in a report last week.

In a technical default, only the prices of Treasury bonds that mature or have coupon payments would fall, according to the analysts. Money-market funds wouldn’t be forced to sell government bonds, and the Fed probably would continue accepting them as collateral for emergency cash.

That distinction is nothing more than an effort to downplay the danger of default, according to MIT’s Johnson. Sovereign defaults are always about the political will to pay because most governments can print money to make payments if they want to, Johnson said.

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