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A US technical default would convulse markets. Nothing else is certain AMERICA’S debt is supposedly the world’s safest, backed by trustworthy courts and an unrivalled capacity to raise taxes and print money. Yet thanks to a quirk of law, talk of default is not confined to the European side of the Atlantic.
Unlike most countries America requires two legal steps to run a deficit: one to pass budget bills, the other to borrow the money. Congress sets a ceiling on how much the country may borrow. In the past it has always raised the ceiling before the Treasury ran out of cash, doing so on 16 occasions since 1993 alone. But it often attaches conditions, and this year Republicans who control the House of Representatives are insisting on particularly onerous terms. With the debt and the deficit at their highest in 60 years, they want to see at least $2 trillion in spending cuts over ten years and no tax increases.
If a deal cannot be reached before August 2nd the Treasury says it will be forced to default. It has not specified on what: it could choose to stop paying pensioners and soldiers before it stopped paying interest on its debt. But outright default cannot be entirely ruled out. What happens if the world’s most trustworthy borrower reneges on its debt?
The possibility has not gone unnoticed. Trading in credit-default swaps (CDSs) on Treasury securities has picked up and the price of protection against default, as measured by the CDS spread, has risen (see chart). One-year protection is now almost as expensive as five-year protection. This is more often seen in distressed markets where investors are pricing in an imminent default than with otherwise healthy borrowers with long-term problems.
The illiquidity of the CDS market means it can be prone to misinterpretation. The vast Treasury market itself—for Treasury bills, Treasury bonds and other government securities—remains largely free of anxiety. America’s biggest interest payments occur on the 15th of August, November, February and May. Priya Misra, head of US rates strategy at Bank of America Merrill Lynch, says anyone who thinks America might default for several weeks this summer should sell a bond with interest due on August 15th and buy one with interest due on November 15th, which would result in the price of the first bond falling relative to the second. But, she says, neither market pricing nor the chatter of clients shows such a trend.
There is a profound muddle about what a default would entail. Firms usually get a few weeks’ grace to make a payment. Sovereigns typically do not so default would probably be declared the day the Treasury missed a payment.
Some market participants argue such a default would be quickly “cured” and be therefore merely technical. Yet history suggests that even a technical default can be costly. America’s only known instance of outright default (other than refusing to repay debts in gold in 1933) occurred in 1979 when the Treasury failed to redeem $122m of Treasury bills on time. It blamed unprecedentedly high interest from small investors, a delay in raising the debt ceiling and a word-processing-equipment failure. Although it repaid the money and a penalty to boot, a later study by Terry Zivney, now of Ball State University, and Richard Marcus of the University of Wisconsin-Milwaukee found it caused a 60-basis-point interest-rate premium on some federal debt. Today that would cost $86 billion a year or 0.6% of GDP, a hefty penalty for something so avoidable.
A default now would attract more attention, affect more debtholders and reach more deeply into the financial system. More than half of Treasury debt is held abroad, principally by foreign central banks. Such investors would be unlikely to sell overnight since they have few ready alternatives. But they would be reluctant to hold as much in the future; some, like China, are already diversifying their reserves. After Fannie Mae and Freddie Mac, two giant mortgage-financing agencies, had to be rescued by the federal government in 2008, foreigners cut their holdings of these securities and have yet to raise them again even though the firms never defaulted.
Domestic banks would not have to classify their sizeable holdings of Treasuries as non-performing if they thought the default short-lived. But they would suffer nonetheless. Currently Treasuries represent roughly 30% of the collateral that financial institutions such as investment banks use to borrow in the $4 trillion repurchase (“repo”) market. They represent another 4-5% of the $1 trillion in collateral used in the derivatives market. A default could trigger demands by lenders like money-market funds for more or different collateral.
Matthew Zames of JPMorgan Chase, writing on behalf of the securities industry in April, gave warning that this could “lead to deleveraging and a sharp drop in lending”. Money-market funds themselves hold another $338 billion of Treasuries. In the event of a default at least one would probably “break the buck” (ie, fail to give the principal back to investors), threatening “a broader run on money funds”, Mr Zames said.
No one can be sure of any of this. Money-market funds, like banks, might argue their holdings are sound if the default is brief. A suspension of new sales of bonds could constrict supply of Treasuries, pushing yields down instead of up. On the other hand America responded to the crisis of 2008 by standing behind the obligations of banks, money-market funds, and Fannie and Freddie. It could hardly do the same for a crisis caused by an inability to stand behind its own debts.
Even if Congress were to tackle turmoil by quickly lifting the debt ceiling, the stain would linger. “In the past our assumption was interest would always be paid on time,” says Steven Hess of Moody’s, a ratings agency which has cautioned that even a brief default would cost America its coveted Aaa status. “If an actual payment were missed once, might that happen again? If you thought it could, that is clearly not compatible with Aaa.” Such warnings are having an effect. On June 19th Mitch McConnell, the Republicans’ leader in the Senate, opened the way to a short-term increase in the debt ceiling, even though his counterparts in the House demurred. They may not show it but Republicans, like Democrats, are scared of default, too.
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