The US debt limit has been reached and the Treasury Department is finding ways to save money. After the maneuvers run out, what once seemed inscrutable may become reality: the United States defaults.
What happens now?
The far-reaching effects are difficult to fully predict: from financial market shocks to bankruptcies, recessions and potentially irreversible damage to the country’s long-held role at the center of the global economy.
The likelihood of a default remains low, at least based on assurances from opposing lawmakers that a deal will be made to raise or suspend the debt limit and the long odds implied by trading in certain financial markets. But as the day approaches when the United States will run out of money to pay its bills — which could be as early as June 1 — investors, executives, and economists around the world are playing up what might happen just before, during, and after. hatching contingency plans and puzzling over largely untested rules and procedures.
“We’re in uncharted waters,” said Andy Sparks, head of portfolio management research at MSCI, which creates indexes that track a wide variety of financial assets, including in the Treasury market.
At the point of default, a ‘horror scenario’ comes into view.
Some corners of the financial markets are already beginning to shake, but those ripples pale in comparison to the tidal wave that builds as default approaches. The $24 trillion U.S. Treasury market is the primary source of government funding as well as the largest debt market in the world.
The treasury market is the backbone of the financial system, an integral part of everything from mortgage interest deductions to the dollar, the world’s most widely used currency. Sometimes government debt is even treated as the equivalent of cash due to the certainty of the government’s creditworthiness.
Destroying confidence in such an entrenched market would have consequences that are difficult to quantify. However, most agree that a default would be “catastrophic,” says Calvin Norris, portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a horror scenario.”
A missed payment sparks a trading frenzy as the markets begin to unravel.
The government pays its debts through banks that are members of a federal payment system called Fedwire. These payments then flow through the conduits of the market and ultimately end up in the accounts of debt holders, including individual savers, pension funds, insurance companies and central banks.
If the Treasury Department wants to change the date it pays back investors, it must notify Fedwire the day before a payment is due so investors know the government was about to default the night before it happened .
Between May 31 and the end of June, there is more than $1 trillion in Treasury debt that could be refinanced to avoid default, according to TD Securities analysts. There are also $13.6 billion in interest payments due over 11 dates; that means 11 different chances for the government to miss a payment over the next month.
Fedwire, the payment system, closes at 4:30 p.m. If a payment due is not met by then, the markets would begin to unravel.
Stocks, corporate debt and the value of the dollar would likely plummet. Volatility can be extreme, not just in the United States but around the world. In 2011, when lawmakers struck a last-minute deal to prevent the debt limit from being breached, the S&P 500 fell 17 percent in just over two weeks. The reaction after a default can be more serious.
Perhaps counterintuitively, government bonds would be in high demand. Investors would likely dump any debt with a payment due soon — some money market funds, for example, have already shifted their holdings from government bonds due in June — and buy others Treasury securities with payments due later in the future, still viewing them as a refuge in a period of stress.
A cascade of rating downgrades creates ‘madness’ for bondholders.
Joydeep Mukherji, the primary credit rating analyst for the United States at S&P Global Ratings, said a missed payment would result in the government being viewed as “selective default”, leading it to choose to waive some payments, but is expected to continue to pay other debts. Fitch Ratings has also said it would downgrade the government’s rating in a similar fashion. Such ratings are usually assigned to at-risk companies and government borrowers.
Moody’s, the other major rating agency, has said that if the Treasury misses one interest payment, the credit rating will be downgraded to just below its current highest rating. A second missed interest payment would result in another downgrade.
A large number of government-affiliated issuers would also likely face downgrades, Moody’s noted, from the agencies that support the mortgage market to hospitals, government contractors, railroads, energy companies and defense companies that rely on government funds. It would also include foreign governments with guarantees of their own debt from the United States, such as Israel.
Some fund managers are particularly sensitive to rating downgrades and may be forced to sell their treasury holdings to comply with rules on the minimum ratings of debt they are allowed to hold, putting pressure on their prices.
“I would fear that in addition to the first-order madness, there is also the second-order madness: if you let two of the three big rating agencies downgrade something, for example, you have a bunch of financial institutions that can’t hold on to them.” securities,” said Austan Goolsbee, president of the Federal Reserve Bank of Chicago, at an event in Florida Tuesday night.
The conduits of the financial system are jamming, making trading more expensive and more difficult.
Importantly, a default on one government bill, receipt or bond does not lead to a default on all government debts, known as “cross default,” according to the Securities Industry and Financial Markets Association, an industry group. This means that a majority of government debt would remain short-term.
That should limit the effect on markets that rely on government bonds as collateral, such as trillions of dollars worth of derivative contracts and short-term loans called repurchase agreements.
Still, any collateral that is affected by a default must be replaced. CME Group, a major derivatives clearing house, has said that while it has no plans to do so, it could ban short-term government bonds from being used as collateral, or apply discounts to the value of some assets used to secure transactions .
There is a risk that the financial system’s conduits will simply freeze over as investors scramble to reposition their portfolios, while major banks that facilitate trading pull out of the market, making buying and selling just about any asset more difficult.
Amid this turmoil in the post-bankruptcy days, some investors could get a big windfall. After a three-day grace period, about $12 billion in credit default swaps, a type of protection against bond defaults, can be triggered. The decision on payouts is made by an industry committee made up of major banks and fund managers.
The country’s global financial reputation has been permanently tarnished.
As the panic subsides, confidence in the country’s fundamental role in the global economy may change permanently.
Foreign investors and governments own $7.6 trillion, or 31 percent, of all government bonds, making them vital to the favorable financing conditions the U.S. government has long enjoyed.
But following a default, the perceived risk of holding government debt could rise, making it more expensive for the government to borrow in the near future. The central role of the dollar in world trade can also be undermined.
Higher borrowing costs from the government would also make it more expensive for companies to issue bonds and take out loans, and raise interest rates for consumers who take out mortgages or use credit cards.
According to White House forecasts, even a brief bankruptcy would lead to the loss of half a million jobs and a somewhat superficial recession. A prolonged bankruptcy would push those numbers up to a devastating eight million lost jobs and a severe recession, with the economy shrinking by more than 6 percent.
Many believe that these potential costs — altogether unknowable but widely regarded as enormous — will motivate lawmakers to reach an agreement on the debt limit. “Every leader in the room understands the consequences if we don’t pay our bills,” President Biden said in a speech Wednesday, as negotiations between Democrats and Republicans intensified. “The nation has never defaulted on its debts, and it never will,” he added.