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Hundreds of banks, hedge funds and investment managers could begin holding multiple daily conference calls as early as June to deal with the fallout from a potential US debt default, kickstarting an “emergency glass-breaking” plan that has never been done before been tried before.
If the Treasury Department intends to miss a scheduled payment to bondholders, financial institutions would learn about it the night before in a call from officials at the Federal Reserve’s division, which manages electronic trading in government securities.
The conference calls are part of a roadmap being developed by the Securities Industry and Financial Markets Association to help buyers and sellers of government securities deal with disruption to normal market operations due to computer failures, natural disasters, terrorism — or political infighting over the government’s securities country – deal finances.
SIFMA’s planning seeks to bring certainty to a situation of high stakes and unknowns. As the nation heads toward a default, no one knows exactly when the government will run out of money, what it will do if it does, or how investors will react.
What is known is bad enough.
The country’s leaders are playing with the unique financial tool that global markets use as a benchmark for valuing all other assets. Investors look to government bonds as the next best thing to cash. They use them as a safe place to park excess funds, as well as a secure source of collateral for Federal Reserve loans and sophisticated financial deals with other institutions.
A default would turn the $24 trillion Treasury market upside down, spreading doubt and higher borrowing costs through key financial channels, including those that companies rely on for short-term financing. Even a “technical default” of just a few days would be enough to lurch the stock market and potentially plunge the economy into recession, economists warn.
“Government offices form the basis for the entire financial system. So many things tie into it,” said David Vandivier, a former Treasury Department official and now executive director of Georgetown University’s Psaros Center for Financial Markets and Policy. “When you don’t have a benchmark anymore, it’s really hard to say what’s going to happen. We just know it’s going to be bad.”
Most financial market experts remain convinced that President Biden and House Speaker Kevin McCarthy (R-California) will reach an agreement before the US government exhausts its resources, according to Treasury Secretary Janet L Yellen will be the case by June 5th.
On Friday there were signs that negotiators were moving closer to an agreement. Newly optimistic investors rushed back into short-dated government bonds they had been avoiding on fears of default, with the yield on a one-month note due June 1 falling more than 1.5 percentage points from its recent peak early Thursday.
Difficult votes still need to be taken in the House and Senate for any agreement. As remaining funds dwindle, investors continue to brace for an unprecedented failure to meet the government’s financial commitments.
Since the United States hit its $31.4 trillion debt ceiling in January, Treasury Department officials have used accounting maneuvers to boost government revenues. Once those measures are exhausted, the Treasury Department would try to avoid a default by paying off bondholders before anyone else, according to transcripts of a 2013 Federal Reserve conference call.
Auctions of new short-term government bonds would hopefully raise enough money to cover principal and interest payments on maturing debt while other government obligations — to Social Security recipients, government employees, and veterans — remain unpaid.
“It won’t initially be the bond market that will feel it. It will be people who the government owes salaries or other payments to,” said Rob Haworth, senior investment strategist at US Bank Wealth Management in Seattle.
This strategy could allow the government to avoid a default. But the rating agencies would likely downgrade the United States’ credit rating, raising the government’s borrowing costs and raising the interest rates consumers pay on credit card balances, auto loans and mortgages.
On Wednesday, Fitch Ratings put the United States’ AAA rating on negative watch, adding that it was unlikely that an agreement would be reached before June 1, “would be unlikely to be achieved with a ‘AAA’ rating.” would be compatible.”
In addition to the Treasury Department itself, U.S. government-backed institutions — such as Fannie Mae and Freddie Mac, which support most mortgage financing, and the Federal Home Loan Banks, a source of routine lending to the banking industry — would see their borrowing costs rise .
Washington’s financial failure would cost everyone – for years to come.
In 2011, after Standard & Poor’s downgraded the US credit rating following an earlier showdown over the debt ceiling, investors began calling for higher interest rates to offset the risk of lending to a less creditworthy borrower.
Since then, the United States has been paying one to two percentage points more on its debt than German government bonds, according to Richard Bernstein, the so-called head of Richard Bernstein Advisors, an investment firm in New York.
If a second rating agency downgraded the US, pension funds and endowments, which are only allowed to invest in AAA-rated debt, would be forced to sell their government bonds. That would depress Treasury prices and increase yields, which move inversely with prices, along with Washington’s interest rate bill.
Attempts to avoid payment defaults could also fail. Amid the turmoil surrounding an ongoing political row over raising the debt ceiling, investors may shy away from the auctions, which could result in the Treasury running out of cash and missing a payment.
Should there be a default, Washington and Wall Street would try to keep going as much as possible.
“I don’t think we would ever get to the point where we would default,” said Nathan Sheets, Citigroup’s chief economist and undersecretary for international affairs in the Obama administration. “I think we could hold out for a longer period of time and still avoid a default.”
The SIFMA contingency plan provides for up to five conference calls per day as long as a payment disruption is ongoing. Association executives, representatives of Fedwire Securities Service, the electronic system that handles treasury transactions, and other key players would brief global investors.
Industry executives expect Treasury Department officials will extend the payment deadline by a day the night before if the government lacks funds to make a required payment on a maturing bond. In this way, the defaulted security could continue to be traded.
Getting this untested system up and running “would present significant operational difficulties and require manual intervention for nearly all market participants,” according to a December 2021 paper from the Treasury Market Practices Group, an industry advisory body failing to provide advance notice of a missed payment would freeze the affected security at Fedwire, potentially hampering trading in the world’s most important market.
The impact of a default is so concerning because of the unique role government bonds play in the global financial system.
For example, if a bank posts government bonds as collateral for a loan in the Fed’s discount window, the central bank credits them at full market value. If the bank deposits some sort of corporate bond instead, the Fed credits it with 85 percent of the value. Some mortgage-backed securities, whose prices are more volatile, are booked at 60 percent.
Government bonds enjoy this special status due to their decades-long track record in trading. When investors buy government bonds, they are guaranteed regular interest payments and repayment of their principal if they hold a bond to maturity.
Investors can obtain higher returns by buying bonds from large companies, but they must accept the risk that the company will fail and be unable to repay the bonds. Even bigger gains can be made by betting on individual company stocks, which are riskier than bonds.
But all of these stocks and corporate bonds are priced in comparison to the guaranteed return that the risk-free Treasury offers.
If that rate of return is no longer guaranteed – because the government decides not to make a scheduled payment – the value of government bonds would no longer be known for certain. And if investors weren’t sure how much government bonds are worth, they wouldn’t be sure how much anything else is worth either.
If the value of government bonds fluctuated or fell, institutions that had pledged them as collateral for a loan or derivative contract could be required to book more.
The result could be a fire sale as investors flee stocks and bonds to amass cash. Markets that have risen sharply this year, like the tech-rich Nasdaq, which is up more than 20 percent, could be particularly vulnerable.
In the 2011 debt ceiling dispute, the Standard & Poor’s 500 index fell nearly 19 percent between early July and early October, when the crisis was over.
Still, William Foster, senior vice president of Moody’s Sovereign Risk Group, said he expects a quick end to a default.
“It would be very short-lived. Just a few days,” he said. “The political pressure and market impact would be such that lawmakers would quickly come to an agreement to resolve the issue.”
Even if the debt ceiling is raised, this episode of risk will still reverberate.
The Treasury Department’s desperate fiscal maneuvers during weeks of political negotiations have left the Treasury Department’s overall balance sheet at just $39 billion, down from almost $819 billion a year ago.
According to Marc Chandler, chief market strategist for the Treasury, the Treasury will need to issue an unusually large number of short-term debt securities to replenish its depleted coffers, which will drain liquidity from the private sector and act as a brake on an economy that is already slowing Bannockburn Global Forex. In addition, the government spending cuts that are part of any deal will weaken the momentum of the economy.
“We really underestimate what’s going to happen if the debt ceiling goes up,” Chandler said.
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