I’d like to think Joe Biden, Kevin McCarthy, Chuck Schumer and Mitch McConnell understand the potential ramifications of a technical US debt default, but they surely don’t.
To the extent they’re bereft when it comes to appreciating the gravity of deliberately undermining the “full faith and credit” pledge at the heart of the global financial system, they’re in good company. No one is capable of war-gaming this.
The channels through which a US default would propagate are so myriad, the possibilities for upheaval so multifarious, you’d need A.I. to draw a blueprint, and even there you couldn’t preemptively determine the psychological impact.
Current and former TBAC leaders attempted to communicate the scope of the peril on Tuesday in a letter to Janet Yellen, who at least understands the situation better than politicians, even as that’s a very low bar. “The role of the Treasury market as backbone of the entire financial system cannot be overstated,” a collection of Committee Chairs and Vice Chairs said, adding that,
Trading in and financing of US Treasury securities would be called into question, leaving the market without a benchmark pricing curve and causing investors to pull back from fixed income and equity markets. Market intermediaries would reduce liquidity provision amidst increasing volatility, heightened operational risks and concerns about credit worthiness and collateral eligibility. The validity of Treasurys as eligible collateral for margin would be called into question, with devastating consequences for interest rate derivative, commodity and mortgage markets.
In short: There isn’t a market (or an asset) on Earth that wouldn’t be roiled by a default, and as TBAC went on to emphasize, such an outcome would almost surely turn March’s regional banking turmoil into a full-blown crisis.
It’s not unreasonable to suggest that lending to businesses and households would freeze up entirely in the event of a protracted stalemate beyond the x-date. It’s also not entirely unreasonable to suggest that equity markets would have to be closed. If the US is in default, and the country’s elected representatives demonstrate a willingness to perpetuate the situation or an unwillingness to cure it immediately, market making could be severely impaired. Algos wouldn’t understand the existential nature of the crisis, but they’d see the volatility, and they’d pull back accordingly. Human market makers would be deer in headlights. There wouldn’t be any liquidity.
Payment prioritization at Treasury is apparently off the table. So, as TD’s Priya Misra put it in a new note, “Treasury will either make all coupon and principal payments or if they do not have sufficient cash to make all payments, they will make none.” That’s probably for the better, because as she went on to suggest, trying to pick and choose which payments to make could be even more disruptive than a blanket non-payment. “The act of not paying even some obligations could send markets into a tailspin,” she said.
Although it’s impossible to be “prepared” for a US default, SIFMA and TMPG have engaged in what Misra described as “a significant amount of operational preparation.” She summarized three possible scenarios:
- Delay of principal payment: This would extend the maturity date of an issue, resulting in a new operational maturity date on Fedwire for coupon and principal payments. These securities can continue to be traded in the market. All interest payments will be made for the originally scheduled payment date while principal payments will be made the night before the operational maturity date. Interest will likely accrue on the delayed payment, and a rate will be announced for compensation. The maturity extension decision will be made “one day at a time” where each day Fedwire will make the determination if Treasury has the ability to make the payment or not.
- Delay of coupon payment: Securities with delayed coupons remain tradable on Fedwire. Fedwire does not calculate any make-up interest payments, so the Treasury would need to decide how to operationalize the payments. Interest does not automatically accrue on delayed payments, similar to principal payments. The coupon payment would be made as of the close of business the day before the originally scheduled coupon payment date within Fedwire — this allows the system to continue to track the proper coupon amounts with less manual intervention.
- Treasury fails to make payment and Fedwire remains unchanged, rendering impacted instruments non-transferable: This is a highly unlikely scenario, but if no extension is made on the maturity date in Fedwire, the securities cannot be transferred to another holder. This scenario would be extremely challenging across markets.
As for collateral, Misra said “CCP participants [would] need to replace impacted Treasury bonds with eligible bonds,” and noted that given what would almost surely be chaotic market conditions in the event of a default, elevated volatility would likely mean an “across-the-board” margin hike.
Like the 17 TBAC officials who wrote to Yellen, Misra warned of “catastrophic consequences” in the event of “even a short payment delay.” Confidence — and not just market confidence — could deteriorate dramatically if the negotiations go down to the wire. In an actual default, all bets are off, just like all payments.
On Tuesday, the TBAC letter described the current brinksmanship inside the Beltway as “reckless and irresponsible.” The officials were being diplomatic. As difficult as it is to map out the market ramifications of a US default, it’s even more challenging to say what the societal implications might be. Americans’ trust in their government has never been shakier. If that government stops making good on its financial obligations to voters, particularly obligations to which voters are entitled or, say, stops paying the salaries of troops, whatever’s left of the public’s faith in the viability of the nation’s institutions could be shattered entirely. It’s also reasonable to suggest that a default would materially increase the odds of another anomalous presidential outcome in 2024, whatever that means to you.
Finally, the de-dollarization debate would shift into high gear if the US defaulted, and for once, adherents and proponents would have an unassailable case. America would be saying to the world that US Treasurys are more or less likely to be a good investment (or good collateral) depending on how rancorous the political environment is in D.C.
As the TBAC letter put it, “The short-term impacts of a protracted negotiation are costly; the long-term implications of a default are unthinkable.”
That’s not hyperbole. I avoided addressing it in hyperbolic terms until now, but the risk of a worst-case scenario is plainly higher than it was in previous standoffs. Given the role played by McCarthy’s rightmost flank, I’m compelled to note that lawmakers who’ve shown very little in the way of regard for decorum around democratic norms are unlikely to be swayed by relatively esoteric arguments about, for example, the role of Treasurys as collateral.
None of this will be real until it is. If it becomes real, I don’t think it’s a stretch (at all) to suggest the market fallout would be considerably worse than March of 2020, assuming one or two days of total chaos wasn’t enough to bring everybody around in D.C. If it were to go on for, say, a month, the damage to the republic would likely be irreparable.
If Schumer and the Senate had a half a brain, they would repeal the law that makes this nonsense possible. Pass it on to the house of representatives.
Sadly, that portion of the anatomy is unavailable to these folks. They are much more interested in their side of the aisle and according to a poll I just read, two-thirds of GOP voters think default would be great.
It certainly does seem that a non-inconsequential number of voters want to see this outcome. It’s perplexing why that would be other than utter stupidity and reinforcement of the erosion of educational standards have come home to roost. Regardless, the writing has been on the wall that we were headed down this road for decades. That no one took the threat seriously, is an abdication of duties and another indication of arrogance by those who should have been “smarter”.
We need an Entebbe moment, to deal with these radical right-wingers as the terrorists they truly are. [Not sure how to do this, but I can hope there’s more brilliant and creative minds than mine, who might! H??]
What was it 1982 when my social studies teacher explained very clearly that racial demographics will change dramatically our lifetimes. What I see is that right wing types did not account for this fact and have put together a party held together by bailing wire and duct tape which is obviously incapable of significantly changing or benefitting the cultural and ethnic dynamics at hand. If they can’t own this prosperous country for their own hypocritical self aggrandizing greedy ends, nobody will “by gawd’. They would rather team up with the enemies of our democracy and cling to immorality to attempt to re-assume control under some form autocracy, or some related form of other than democratic system. This debt ceiling chaos is nothing more than the loser’s process in my opinion. If they win democracy loses, they are no longer patriots.
My prediction is constitutional crisis. On the X-date, Biden will site the 14th amendment, (relevant text: “The validity of the public debt of the United States, authorized by law, including debts incurred for payment of pensions and bounties for services in suppressing insurrection or rebellion, shall not be questioned.”), and instruct Secretary Yellen via Executive Order to pay the bills and ignore the debt ceiling. Republicans in Congress will sue, and the Supreme Court will take up the case immediately. If the Supreme Court decides against the Executive, we will be in default, all hell will break loose, as described above. The Republicans, seeing the hell they hath wrought, will fold and vote to raise the debt ceiling (enough of them to make a majority with Democrats anyway). If the Supreme Court rules in favor of the Executive, then the old debt ceiling law will be void, and we’ll never have to hear about this balderdash again.
The alternate scenario would be that Biden and Congressional Leadership negotiate a compromise and sign it in to law. The key to that happening will be people with money picking up the phone and demanding that their bought-and-paid-for Representatives and Senators stop screwing around and just raise the damn thing already.
I’m dense, but I still don’t understand why debt default is likely to follow shortly after the X-date. Surely Treasury is capable of prioritizing debt service, even if the federal government chooses to not prioritize among other bills.
My hope is that Republicans come to their senses (I know it is unlikely). But since that won’t happen, I think that Biden is only left with citing the 14th amendment to write up an executive order to make Yellen pay the bills. The republicans will sue but they will lose like Trump lost all his election denying lawsuits. My hope is maybe we can elect more adults the next election cycle that wouldn’t even consider this possibility in the future.
Fascinating times indeed. I was a bit surprised about how emphatic McConnell sounded yesterday indicating the US would not default on its obligations, to me that is a hint this should be resolved, even if at the 11th hour. I will not be surprised however if Mitch washed his hands from the mess if a deal proved evasive. Will this time be different? Are Congressional GOPers really willing to risk default? They would initially have the support of their base and voters in this crusade to self crucify the nation, and this might be enough to embolden McCarty to go “all in.” I recently read Isabell Wilkerson’s wonderful book “Caste,” towards the end she poses the question of whether a portion of our citizens might chose “witheness” over democracy, I think January 6, 2020 betrayed the answered to that question, we might get a reminder soon, that for a whole group of Americans, their perceived rank on the totem
pole of US society supersedes the wellbeing on our nation, if it can’t belong to them in the absolute just burn it down…
GOP’s only priority is retaining power as the minority, which means obstructing any policy or proposal of the Democrats, and demonizing any of the effects and outcomes the Democrats might achieve. They should really change their name to POCP — the Party Over Country Party.