Possible default threatens foundation of global financial system
The Washington Post May 27, 2023
Hundreds of banks, hedge funds and investment managers as soon as early June could begin holding multiple daily conference calls to handle the fallout from a possible U.S. debt default, activating a "break-glass-in-case-of-emergency" playbook that has never before been tried.
If the Treasury Department intends to miss a scheduled payment to bondholders, financial institutions would find out on a call the night before from representatives of the Federal Reserve division that manages the electronic trading of government securities.
The conference calls are part of a road map developed by the Securities Industry and Financial Markets Association to help buyers and sellers of government securities deal with an interruption in normal market functioning because of computer failures, natural disasters, terrorism - or political battles over the nation's finances.
SIFMA's planning attempts to bring certainty to a high-stakes situation shrouded in unknowns. As the nation hurtles toward a default on its debt, no one knows precisely when the government will run out of money, what it will do when it does, or how investors will react.
What is known is bad enough.
The nation's leaders are gambling with the singular financial instrument that global markets use as the measuring stick against which all other assets are priced. Investors regard treasuries as the next best thing to cash. They use them as a safe place to park excess funds as well as a ready source of collateral for loans from the Federal Reserve and sophisticated financial trades with other institutions.
A default would upend the $24 trillion treasury market, spreading doubt and higher borrowing costs through critical financial channels, including those that businesses rely on for short-term financing. Even a "technical default" lasting a few days would be enough to send the stock market skidding and perhaps tilt the economy into recession, economists have warned.
"Treasurys provide the baseline for the entire financial system. So many things are related to them," said David Vandivier, a former Treasury Department official and now executive director of Georgetown University's Psaros Center for Financial Markets and Policy. "If you don't have a benchmark any more, it's really hard to say what will happen. We just know it's going to be bad."
Most financial market professionals remain convinced that President Biden and House Speaker Kevin McCarthy (R-Calif.) will reach a deal before the U.S. government exhausts its funds, which will happen by June 5, according to Treasury Secretary Janet L. Yellen's latest assessment.
On Friday, there were indications that negotiators were closing in on a deal. Newly optimistic investors rushed back into short-term treasuries they had shunned amid default fears, with the yield on a one-month bill maturing June 1 plunging by more than 1.5 percentage points from its recent high early Thursday.
Any deal still faces tough votes in the House and Senate. So as the remaining funds dwindle, investors continue preparing for what would be an unprecedented government failure to meet its financial obligations.
Since the United States hit its $31.4 trillion debt limit in January, Treasury officials have used accounting maneuvers to stretch government revenue. Once those measures are exhausted, Treasury would try to avoid default by paying bondholders before anyone else, according to the transcript of a 2013 Federal Reserve conference call.
Auctions of new short-term T-bills hopefully would bring in enough money to cover principal and interest payments on maturing debt, so long as other government obligations - to Social Security recipients, government employees and veterans - went unpaid.
"It'll be not the bond market that feels it at first. It'll be people owed salaries or other payments by the government," said Rob Haworth, senior investment strategist for U.S. Bank Wealth Management in Seattle.
That strategy could allow the government to dodge a default. But rating agencies would probably downgrade the United States' creditworthiness, a move that would raise the government's borrowing costs and boost the interest rates that consumers pay on credit card balances, auto loans and mortgages.
On Wednesday, Fitch Ratings placed the United States' "AAA" standing on negative watch, adding that a failure to reach a deal before June 1 "would be unlikely to be consistent with a 'AAA' rating."
Along with the Treasury itself, institutions that are backed by the U.S. government - such as Fannie Mae and Freddie Mac, which support most mortgage financing, and the Federal Home Loan Banks, a source of routine credit for the banking industry - would see their borrowing costs rise.
Washington's financial failure would cost everyone - for years.
In 2011, after Standard & Poor's downgraded the U.S. following an earlier debt ceiling showdown, investors began demanding higher interest rates to compensate for the risk of lending to a less creditworthy borrower.
Since then, the U.S. has been paying an extra 1 to 2 percentage points on its debt, relative to German government bonds, according to Richard Bernstein, so-called leads Richard Bernstein Advisors, an investment firm in New York.
If a second rating agency downgrades the United States, pension funds and endowments that are limited to investing only in 'AAA' rated debt would be forced to sell their treasurys. That would depress government bond prices and raise yields, which move opposite to prices, along with Washington's interest bill.
The effort to avoid default also might fail. Amid the turmoil associated with a prolonged political fight over raising the debt ceiling, investors could shy away from the auctions, causing Treasury to run out of cash and miss a payment.
If a default occurs, Washington and Wall Street would aim to operate as close to business-as-usual as possible.
"I don't think we'd even get to the point where we'd be defaulting," said Nathan Sheets, chief economist at Citigroup and undersecretary of treasury for international affairs in the Obama administration. "I think we could go for quite a long period and still be able to avoid a default."
The SIFMA crisis blueprint calls for up to five conference calls each day, for as long as a payment interruption continues. Association executives, representatives from Fedwire Securities Service, the electronic system that processes treasury trades, and other key players would brief global investors.
Industry executives assume that if the government lacks funds to make a required payment on a maturing bond, Treasury officials the night before will extend the payment due date by one day. In that way, the defaulted security could still be traded.
Getting this untested system to work "would entail significant operational difficulties and require manual intervention for nearly all market participants," concluded a December 2021 paper by the Treasury Market Practices Group, an industry advisory body. If Treasury was unable to provide advance notification of a missed payment, the affected security would be frozen on Fedwire, potentially clogging trading in the world's most important market.
The effects of default are so worrisome because of the unique role that treasurys play in the global financial system.
For example, if a bank posts treasurys as collateral for a loan at the Fed's discount window, the central bank credits them at their full market value. If the bank instead posts a type of corporate bond, the Fed credits it with 85 percent of the value. Some mortgage-backed securities, whose prices are more volatile, are booked at 60 percent.
Treasurys enjoy that special status because of their track record over decades of trading. When investors purchase government securities, they are guaranteed regular interest payments and the return of their principal if they hold a bond to maturity.
Investors can earn higher returns by buying bonds issued by large corporations, but they must accept the risk that the company could fail and be unable to repay. Even larger gains can be realized by betting on the stocks of individual companies, which are riskier than bonds.
But the prices of all of those stocks and corporate bonds are set in comparison to the guaranteed return available from the risk-free Treasury.
If that return is no longer guaranteed - because the government chooses not to make a scheduled payment - treasurys' value no longer would be known for certain. And if investors were unsure how much treasurys were worth, they would be unsure how much everything else is worth, too.
As treasury values wobbled or declined, institutions that had pledged them as collateral for a loan or derivatives contract could be required to post more.
The result could be a fire sale as investors flee stocks and bonds to accumulate cash. Markets that have risen sharply this year, such as the tech-rich Nasdaq, which is up more than 20 percent, could be especially vulnerable.
In the 2011 debt ceiling standoff, the Standard & Poor's 500 index fell nearly 19 percent between early July and early October as the crisis was resolved.
Still, William Foster, senior vice president for Moody's sovereign risk group, said he expects any default to end quickly.
"It would be very short-lived. Just a few days," he said. "There'd be enough political pressure and market fallout that lawmakers would quickly come to an agreement to resolve the issue."
Even once the debt ceiling is raised, this episode of brinkmanship will reverberate.
Treasury's desperate financial maneuvering during weeks of political bargaining has left its general account balance with just $39 billion, down from almost $819 billion one year ago.
Treasury will need to issue an unusually large amount of short-term bills to refill its depleted coffers, which will drain liquidity from the private sector and act as a brake on an economy that already is slowing, according to Marc Chandler, chief market strategist for Bannockburn Global Forex. Plus, the government spending cuts that will be part of any deal will sap the economy's momentum.
"We're really understating what will happen when the debt ceiling is raised," Chandler said.