What Would Happen If the US Defaulted on Its Debt

Author: Yuvi May 19, 2023 What Would Happen If the US Defaulted on Its Debt

The US debt limit has been reached and the Treasury Department is finding ways to save cash. After it runs out of maneuvers, what once seemed unfathomable could become reality: The United States defaults.

What happens next?

The far-reaching effects are hard to fully predict: from shock waves in financial markets to bankruptcies, recessions and potentially irreversible damage to the nation’s long-held role at the center of the global economy.

The probability of a default remains low, at least based on opposing lawmakers’ assurances that a deal will be done 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 begins to run out of cash to pay its bills — which could be as soon as June 1 — investors, executives and economists around the world are gaming out what might happen immediately before, during and after, hatching contingency plans and puzzling over largely untested rules and procedures.

“We are sailing into uncharted waters,” said Andy Sparks, head of portfolio management research at MSCI, which creates indexes that track a wide range of financial assets, including in the Treasury market.

Some corners of the financial markets have already begun to shudder, but those ripples pale in comparison to the tidal wave that builds as a default approach. The $24 trillion US Treasury market is the primary source of financing for the government as well as the largest debt market in the world.

The Treasury market is the backbone of the financial system, integral to everything from mortgage rates to the dollar, the most widely used currency in the world. At times, Treasury debt is even treated as the equivalent of cash because of the certainty of the government’s creditworthiness.

Shattering confidence in such a deeply embedded market would have effects that are hard to quantify. Most agree, however, that a default would be “catastrophic,” said Calvin Norris, a portfolio manager and interest rate strategist at Aegon Asset Management. “That would be a horror scenario.”

The government pays its debts through banks that are members of a federal payments system called Fedwire. These payments then flow through the market’s plumbing, eventually ending up in the accounts of debt holders, including individual savers, pension funds, insurance companies and central banks.

If the Treasury Department wanted to change the date it repays investors, it would need to notify Fedwire the day before a payment is due, so investors would know the government was about to default the night before it happened.

There is more than $1 trillion of Treasury debt maturing between May 31 and the end of June that could be refinanced to avoid default, according to analysts at TD Securities. There are also $13.6 billion in interest payments due, spread out over 11 dates; that means 11 different opportunities for the government to miss a payment over the course of next month.

Fedwire, the payment system, closes at 4.30 pm If a payment due is not made by this time, at the very latest, the markets would begin to unravel.

Stocks, corporate debt and the value of the dollar would probably plummet. Volatility could be extreme, not just in the United States but across the world. In 2011, around when lawmakers struck a last-minute deal to avoid breaching the debt limit, the S&P 500 fell 17 percent in just over two weeks. The reaction after a default could be more severe.

Perhaps counterintuitively, some Treasury bonds would be in high demand. Investors would likely dump any debt with a payment coming due soon — for example, some money market funds have already shifted their holdings away from Treasuries that mature in June — and buy other Treasury securities with payments due further in the future, still seeing them as a haven in a period of stress.

Joydeep Mukherji, the primary credit rating analyst for the United States at S&P Global Ratings, said that a missed payment would result in the government being considered in “selective default,” by which it has chosen to renege on some payments but is expected to keep paying other debts. Fitch Ratings has also said it would slash the government’s rating in a similar way. Such ratings are usually assigned to imperiled companies and government borrowers.

Moody’s, the other major rating agency, has said that if the Treasury misses one interest payment, its credit rating would be lowered by a notch, to just below its current top rating. A second missed interest payment would result in another downgrade.

A slew of government-linked issuers would also likely suffer downgrades, Moody’s noted, from the agencies that underpin the mortgage market to hospitals, government contractors, railroads, power utilities and defense companies reliant on government funds. It would also include foreign governments with guarantees on their own debt from the United States, such as Israel.

Some fund managers are particularly sensitive to ratings downgrades, and may be forced to sell their Treasury holdings to meet rules on the minimum ratings of the debt they are allowed to hold, depressing their prices.

“I would fear, besides the first-order craziness, there’s second-order craziness too: Like, if you get two of the three of the major rating agencies downgrade something, then you have a bunch of financial institutions that can’t hold those securities,” Austan Goolsbee, president of the Federal Reserve Bank of Chicago, said at an event in Florida on Tuesday night.

Importantly, a default on one government bill, note or bond does not trigger a default across all of the government’s debt, known as “cross default,” according to the Securities Industry and Financial Markets Association, an industry group. This means that a majority of the government’s debt would remain current.

That should limit the effect on markets that rely on Treasury debt for collateral, such as trillions of dollars worth of derivatives contracts and short-term loans called repurchase agreements.

Still, any collateral affected by a default would need to be replaced. CME Group, a large derivatives clearing house, has said that while it has no plans to do so, it could prohibit short-dated Treasuries 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 pipes simply freeze over, as investors rush to reposition their portfolios while big banks that facilitate trading step back from the market, making buying and selling just about any asset more difficult.

Amid this tumult in the days after a default, a few investors could be in for a major windfall. After a three-day grace period, some $12 billion of credit default swaps, a type of protection against a bond default, may be triggered. The decision on payouts is made by an industry committee that includes big banks and fund managers.

As panic subsides, confidence in the nation’s fundamental role in the global economy may be permanently altered.

Foreign investors and governments hold $7.6 trillion, or 31 percent, of all Treasury debt, making them vital to the favorable financing conditions that the US government has long enjoyed.

But after a default, the perceived risk of holding Treasury debt could rise, making it more costly for the government to borrow for the foreseeable future. The dollar’s central role in world trade may also be undermined.

Higher government borrowing costs would also make it more expensive for companies to issue bonds and take out loans, as well as raise interest rates for consumers taking out mortgages or using credit cards.

Economically, according to forecasts by the White House even a brief default would result in half a million lost jobs and a somewhat shallow recession. A protracted default would push those numbers to a devastating eight million lost jobs and a severe recession, with the economy shrinking by more than 6 percent.

These potential costs — unknowable in total but widely thought to be enormous — are what many believe will motivate lawmakers to reach a deal on the debt limit. “Every leader in the room understands the consequences if we fail to pay our bills,” President Biden said in a speech on Wednesday, as negotiations between Democrats and Republicans intensified. “The nation has never defaulted on its debt, and it never will,” he added.

Author: Yuvi

My name is Yuvi, I work as Sub Editor at newscinema.in

19 May, 2023, 12:31 am

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