The United States is drawing closer to disaster as lawmakers continue to debate what it takes to raise the country’s $31.4 trillion debt ceiling.
This has raised questions about what would happen if the United States didn’t raise its borrowing limit in time to avoid a default, how key players are preparing for that scenario, and what would actually happen if the Treasury failed to repay their debt lenders.
Such a situation would be unprecedented, so it is difficult to say with certainty how it would play out. But it’s not the first time investors and policymakers have had to think “what ifs?” and they’ve been busy updating their game plans for how things might play out this time.
While negotiators are talking and appear to be moving towards an agreement, time is of the essence and there is no certainty that the debt limit will be lifted before June 1, the earliest the Treasury Department expects the government to run out of cash to pay all debt bills on time, known as “X-date”.
Big questions remain, including what might happen in the markets, how the government plans to default, and what happens if the United States runs out of cash. Here’s a look at how things might play out.
Before the X date
Financial markets have become more nervous as the US approaches the X-date. This week Fitch Ratings announced that it was reviewing the country’s top AAA credit rating for a possible downgrade. DBRS Morningstar, another rating company, did the same on Thursday.
Currently, the Treasury continues to sell debt and make payments to its lenders.
This has helped allay some concerns that the Treasury will not be able to fully repay the debt as it falls due, only making an interest payment. That’s because the government regularly holds new Treasury auctions, where it sells bonds to raise fresh money. The auctions are scheduled so that the Treasury receives the new borrowed money at the same time as it pays off its old debt.
This allows the Treasury Department to avoid increasing its $31.4 trillion outstanding debt burden — something it can’t do right now, having enacted extraordinary measures after narrowly missing the deadline on Jan. 19 debt limit was reached. And it should give the Treasury the ability It needs sufficient cash to avoid payment disruption, at least for now.
For example, this week the government sold two-year, five-year and seven-year bonds. However, that debt will not be “paid off” until May 31, meaning the cash will be handed over to the Treasury and the securities will be handed over to buyers at the auction when three more securities mature.
More specifically, the newly borrowed cash is slightly more than the amount due. The Treasury borrowed $120 billion this week through the three different debentures. While about $150 billion of debt matures on May 31, about $60 billion of that is being held back by the government from previous crisis interventions in the market, meaning it will ultimately pay off that portion of the debt itself, leaving an additional $30 billion in cash, according to analysts at TD Securities.
Some of that could go towards the $12 billion in interest payments that the Treasury Department also has to pay that day. But over time, and as the debt limit becomes more difficult to circumvent, the Treasury Department may have to delay any additional fundraising, as it did during the debt limit standoff in 2015.
After X date, before failure
The US Treasury pays its debt through a federal payment system called Fedwire. Large banks maintain accounts with Fedwire, and the Treasury credits these accounts with payments on its debt. These banks then funnel the payments down the market’s conduits and through clearing houses like the Fixed Income Clearing Corporation, eventually ending up in the accounts of holders, from domestic retirees to foreign central banks.
The Treasury could try to avert the default by extending the maturity of the debt due. Because of the way Fedwire is set up, in the unlikely event that the Treasury wanted to postpone the maturity of its debt, it would have to do so no later than 10 p.m. the day before the debt was due, according to contingency plans issued by trade group Securities Industry and Financial Markets Association (SIFMA). The Group assumes that in this case the term will only be extended by one day.
Investors worry that should the state exhaust its available cash, it could miss an interest payment on its other debt. The first major test of this will come on June 15, when interest payments on debentures and bonds with original maturities greater than one year are due.
Moody’s, the rating agency, has said June 15 is the possible date for the government to default. However, it might help that next month’s corporate taxes will pour into the coffers.
According to SIFMA, the Treasury cannot delay an interest payment without default, but it could notify Fedwire by 7:30 a.m. that the payment will not be ready by morning. You would then have until 4:30 p.m. to make the payment and avoid late payment.
When a default is feared, SIFMA – along with representatives from Fedwire, the banks and other industry stakeholders – has plans to convene up to two calls the day before a possible default and three more calls on the day a payment is due. with each call following a similar script to update, assess and plan what may develop.
“I think we have a good idea of what could happen in terms of settlement, infrastructure and sanitation,” said Rob Toomey, SIFMA’s head of capital markets. “It’s about the best we can do. As for the long-term consequences, we don’t know. We try to minimize disruption in a situation that will lead to disruption.”
standard and beyond
A big question is how the United States will determine if it has in fact defaulted on its debt.
There are two main ways that the Treasury could default; misses an interest payment on its debt or fails to repay its loans when the full amount is due.
This has led to speculation that the Treasury may prioritize payments to bondholders over other bills. If bondholders get paid but others don’t, rating agencies are likely to conclude that the United States has escaped a default.
But Treasury Secretary Janet L. Yellen has hinted that any missed payment would essentially be a default.
Shai Akabas, director of economic policy at the Bipartisan Policy Center, said an early warning sign of an impending default could come in the form of a failed Treasury auction. The Treasury will also closely monitor its spending and incoming tax revenues to anticipate when defaults might occur.
At that point, Mr. Akabas said, it was likely that Ms. Yellen would issue a warning and specify the exact time when she believes the United States will not be able to make all of her payments on time and those she intends to make to announce contingency plans.
Investors will also receive updates from industry groups tracking key deadlines by which the Treasury Department must notify Fedwire that it will not be making a scheduled payment.
A default would then trigger a cascade of potential problems.
Rating firms have said that a default would justify a US debt downgrade – and Moody’s has said the AAA rating will not be restored until the debt ceiling is no longer subject to political risk.
International leaders have questioned whether the world should continue to tolerate repeated debt crises given the United States’ integral role in the global economy. Central bankers, politicians and economists have warned that a default is likely to plunge America into recession, leading to second-order waves of everything from corporate failures to rising unemployment.
But these are just some of the risks that are known to lurk.
“This is all new territory,” said Mr. Akabas. “There are no rules that you can use as a guide.”
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