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Possible default threatens foundation of global financial system

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 possible US debt default, triggering an “emergency glass breaker” that has never been tried before.

If the Ministry of the Treasury intends to miss the planned payment to the bondholders, the financial institutions would find out about it on a call the night before from a representative of the Federal Reserve department that manages the electronic trading of government securities.

The conference calls are part of a roadmap developed by the Securities Industry and Financial Markets Association to help buyers and sellers of government securities deal with disruptions to the normal functioning of markets due to computer failures, natural disasters, terrorism — or political battles over the nation’s finances .

SIFMA’s planning attempts to bring certainty to a high-stakes situation shrouded in unknowns. As the nation races toward debt default, no one knows exactly when the government will run out of money, what it will do when it does, or how investors will react.

What is known is bad enough.

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The nation’s leaders are gambling with a single financial instrument that global markets use as a yardstick against which all other assets are measured. Investors see Treasuries as the next best thing to cash in on. They use them as a safe place to park excess funds, as well as a ready source of collateral for Federal Reserve loans and sophisticated financial transactions with other institutions.

A default would destroy the $24 trillion Treasury market, spreading doubt and higher borrowing costs through critical financial channels, including those businesses rely on for short-term financing. Economists warn that even a “technical default” lasting a few days would be enough to cause the stock market to slide and possibly lead the economy into recession.

“Treasury provides the basis for the entire financial system. There are so many things tied to them,” said David Vandivier, a former Treasury Department official who is now executive director of Georgetown University’s Psaros Center for Financial Markets and Policy. “If you don’t have a yardstick anymore, it’s really hard to tell what’s going to happen. We just know it’s going to be bad.”

Most financial market experts remain confident that President Biden and House Speaker Kevin McCarthy (R-Calif.) will reach a deal before the U.S. government runs out of funds, which will happen by June 5, according to the latest estimate from Treasury Secretary Janet L. Yellen.

On Friday, there were indications that negotiators were closing in on a deal. Newly bullish investors rushed back into short-term Treasuries that they had shunned over default fears, with the yield on the one-month note due June 1 down more than 1.5 percentage points from Thursday’s recent high.

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Any deal still faces tough votes in the House and Senate. So, as remaining funds dwindle, investors continue to brace for what would be an unprecedented failure by the government to meet its financial obligations.

Since the United States reached the $31.4 trillion debt limit in January, Treasury officials have used accounting maneuvers to increase government revenue. When those measures are exhausted, the Treasury Department will try to avoid a default by paying bondholders before anyone else, according to a transcript of a 2013 Federal Reserve conference call.

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The hope is that auctions of the new short-term Treasury bills will bring in enough money to cover the principal and interest payments on the maturing debt until other government obligations — to Social Security recipients, government employees and veterans — are paid.

“At first, the bond market will not feel it. Those will be people who are owed wages or other payments from the government,” said Rob Haworth, senior investment strategist at US Bank Wealth Management in Seattle.

That strategy could allow the government to avoid default. But rating agencies would likely downgrade the United States’ creditworthiness, a move that would raise the government’s borrowing costs and raise the interest rates consumers pay on credit cards, auto loans and mortgages.

Fitch Ratings put the US “AAA” on negative watch on Wednesday, adding that failure to reach a deal before June 1 “is unlikely to be consistent with the ‘AAA’ rating.”

Along with the Treasury itself, U.S. government-backed institutions — like Fannie Mae and Freddie Mac, which back most mortgage financing, and the Federal Home Loan Bank, a source of routine loans for the banking industry — could see their borrowing costs rise.

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In 2011, after Standard & Poor’s downgraded the US after earlier lowering the debt ceiling, investors began demanding higher interest rates to compensate for the risk of lending to a less creditworthy borrower.

Since then, The US is paying an extra 1 to 2 percentage points on its debt, compared to German government bonds, according to Richard Bernstein, so-called head of Richard Bernstein Advisors, an investment firm in New York.

If another rating agency downgrades the United States, pension funds and funds that are limited to investing only in ‘AAA’ rated debt would be forced to sell their treasuries. That would lower Treasury prices and raise yields, which move against prices along with Washington’s interest bill.

The effort to avoid default can also fail. Amid the turmoil associated with a prolonged political battle over raising the debt ceiling, investors could shun auctions, leaving the Treasury strapped for cash and defaulting on payments.

If a default were to occur, Washington and Wall Street would seek to operate as closely as possible to business as usual.

“I don’t think we would even get to the point where we would miss,” said Nathan Sheets, chief economist at Citigroup and undersecretary of the Treasury for international affairs in the Obama administration. “I think we could go quite a long time and still avoid default.”

SIFMA’s crisis plan provides for up to five conference calls each day for as long as the payment interruption lasts. Association executives, representatives of Fedwire Securities Service, the electronic system that processes treasury transactions, and other key players would brief global investors.

Industry executives assume that if the government lacks the funds to make the required payment on a maturing bond, Treasury officials will extend the maturity date by one day the night before. In this way, the defaulted security can still be traded.

Allowing this untested system to operate “would entail significant operational difficulties and require manual intervention for virtually all market participants,” concluded a December 2021 paper by the Treasury Market Practices Group, an industry advisory body. If the Treasury was unable to provide advance notice of a missed payment, the affected securities would be frozen on Fedwire, potentially blocking trading in the world’s most important market.

The effects of defaults are so worrisome because of the unique role that treasuries play in the global financial system.

For example, if a bank posts Treasuries as collateral for a loan at the Fed’s discount window, the central bank credits them at their full market value. If the bank issues some kind 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.

Treasuries enjoy that special status because of their decades of trading experience. When investors buy government securities, they are guaranteed regular interest payments and a return of their principal if they hold the bond to maturity.

Investors can get higher returns by buying bonds issued by large corporations, but they must accept the risk that the company might fail and be unable to repay. Even bigger gains can be made by betting on individual company stocks, which are riskier than bonds.

But all those stocks and corporate bonds are priced in comparison to the guaranteed return available from the risk-free Treasuries.

If that return is no longer guaranteed — because the government decides not to make the planned payment — the value of the treasury would no longer be known with certainty. And if investors weren’t sure what treasuries were worth, they wouldn’t be sure what everything else was worth.

As the value of Treasuries fluctuated or declined, institutions that pledged them as collateral for a loan or derivatives contract could be required to post more.

The result could be a sell-off as investors flee stocks and bonds to accumulate cash. Markets that have surged this year, such as the tech-rich Nasdaq, which is up more than 20 percent, could be particularly vulnerable.

In the 2011 debt ceiling standoff, the Standard & Poor’s 500 fell nearly 19 percent between early July and early October as the crisis was resolved.

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Still, William Foster, senior vice president of Moody’s sovereign risk group, said he expects any default to end quickly.

“It would be very short-lived. Just a few days,” he said. “There would be enough political pressure and market ramifications for lawmakers to quickly agree to address the issue.”

Even after the debt ceiling is lifted, this episode of sitting on the brink will reverberate.

The Treasury’s desperate financial maneuvering during weeks of political bargaining has left its overall account balance at just $49 billion, down from nearly $819 billion a year ago.

The Treasury will need to issue an unusually large amount of short-term bills to fill its depleted coffers, draining liquidity from the private sector and acting as a drag on an already slowing economy, said Marc Chandler, chief market strategist at Bannockburn Global Forex. In addition, the cuts in government spending that will be part of any deal will dampen the economy’s momentum.

“We really underestimate what will happen when the debt ceiling is raised,” Chandler said.

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