WASHINGTON — If Congress can’t agree to an adjustment to the debt ceiling, Wall Street could face apocalyptic consequences.
Banks and other financial firms benefit from the longstanding assumption that the United States will always pay its debts. Treasuries underpin the entire global financial system because of that stability, and changing that assumption could create a far-reaching ripple effect affecting everything from overnight repo transactions to home mortgage prices. households.
The United States stared down the barrel of debt default during the Obama administration in 2011, but averted total disaster with just days to spare. Even so, the confrontation affected the markets and led to a downgrade of US debt by S&P Global, giving the financial world an idea of what could happen with this twist.
And the risk that brinkmanship will lead to an actual default is substantially higher this time around, experts agree. Reticent conservative Republicans who fought Rep. Ken McCarthy’s bid for House speaker have little consensus on what they want from debt ceiling negotiations with President Biden and Democratic lawmakers, and McCarthy is unlikely to have the political clout to keep them in line during a vote.
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Even Wall Street, which has grown increasingly tolerant of Washington’s antics since it came close to crisis in 2011, is starting to take notice. JPMorgan CEO Jamie Dimon said last week that America’s solvency should be “sacrosanct” and questioning it “should never happen,” while Goldman Sachs economists in a recent note said the debt ceiling ” It’s going to be a problem.” .”
“Most large financial institutions feel they need to engage in contingency planning under the assumption that you really can’t know if policy risky will work itself out this time,” said David Portilla, head of banking regulatory practice at Cravath, Swaine. & Moore. .
The consequences
The exact consequences of a debt default, which would not occur until the country is unable to pay its bills on the so-called “X date” sometime this summer, are murky for both forecasters and the Treasury Department. . It’s an unproven theory, as the United States has never intentionally defaulted on its debt before.
“Bank holding companies and markets in general tend to assume that Treasuries are risk-free with relatively understood market behavior and volatility; if those assumptions prove incorrect, there could be significant consequences that are difficult to know in detail for advanced”. Portilla said.
But there is no doubt that a default would be disastrous for financial companies and for financial stability in general.
“I think from a layman’s point of view, defaulting on Treasury debt would make Lehman’s failure look like a walk in the park on a sunny day,” said Ed Groshans, senior research and policy analyst. from Compass Point Research & Trading.
If the Treasury Department could not pay its loans, investors would demand much higher rates in the future to lend money to the government. That could lead to a spiral, with the government finding it increasingly expensive to borrow money, and Congress having to raise the debt ceiling at an even faster rate in the future.
Bond markets are another big concern. In a repurchase agreement, or repo, a company such as a stockbroker may need cash to finance its operations. They may offer a Treasury security to another party for cash with the agreement that the original broker-dealer will repurchase the Treasury security in the future at a nominal interest margin.
The current expectation is that a repo deal can “roll” overnight, meaning that if a stockbroker replaces Treasuries to raise cash for his own financing needs, and buys them back tomorrow, he can do the same again. Essentially, they use short-term financing to finance long-term assets.
If people believe that Treasuries are going to default, those Treasuries are no longer a desirable collateral. Repo transaction fees could increase, or there could be a big change in the way brokers find short-term financing.
“Treasuries are generally considered essentially risk-free investments when held as a placeholder before capital is deployed elsewhere,” Portilla said. “That assumption that is not true could be destabilizing.”
Deposits in banks could also be greatly affected. If investors suddenly decide that Treasuries are no longer risk-free, they would probably look for risk-free investments and banks could see an inflow of deposits. This would be a situation roughly similar to March 2020, when Treasury markets almost ground to a halt and bank deposits rose precipitously.
Although this would be increase some business in banksthat have recently had trouble attracting deposits, would occur when the Federal Deposit Insurance Corporation has said that it is concerned about keeping the Deposit Guarantee Fund at the legal minimum. Therefore, a sudden influx of deposits could pose a risk to financial stability if the FDIC does not have enough in its fund to bail out failing banks, especially during a time of economic stress.
Even home loan rates and energy prices would feel the sting, Groshans said.
The mortgage market is broadly based on 10-year Treasury yields, he said, and generally the higher 10-year Treasury rates, the more mortgage rates will rise. That’s also true in reverse: Lower 10-year Treasury yields translate to lower mortgage interest rates for homebuyers.
“If people get nervous and think Treasuries are going to default and sell them, the yield on those bonds will go up,” Groshans said. “If we use the current spread, and if people get out of Treasuries, I think we’re looking at mortgage rates closer to 10%.”
It would also simply result in less capital in the financial markets, Groshans said. Treasuries have generally served as collateral, and making them less stable would make it more expensive to finance other financial instruments and investments.
“Whoever provided me with that guarantee, I would tell them to give it back or I’ll make a margin call,” Groshans said. “You could start to see that the liquidity that is in the system could be recovered from those margin calls and there would be less capital circulating through the system, therefore less investment overall.”
The Fed’s New Moral Hazard
Initially, containing the consequences of a debt default would fall to the Federal Reserve. In 2011, Fed officials, including now Treasury Secretary Janet Yellen, discussed the possibilityand central bank options in case of default.
Specifically, the officials discussed the purchase of defaulted Treasury bonds. This could calm bondholders’ fears and keep markets running until the Treasury can resume payments.
But that’s not likely to happen, experts say.
“Frankly, I think they would do the same.” platinum coin before they did that,” said Lou Crandall, chief economist at Wrightson ICAP. “I’m not even sure that’s legal.”
For one thing, it would present the Federal Reserve with another moral hazard dilemma, propping up an industry because of its importance to the financial system.
“It is critical that money funds manage their liquidity without extraordinary assistance, even in difficult circumstances, and that designing a facility to provide money funds with liquidity, as suggested in the memorandum, without creating substantial moral hazard would be very difficult. “said an official. during the 2011 meeting.
Fed Chairman Jerome Powell during another period of uncertainty over the debt ceiling in 2013He called the idea of buying defaulted Treasuries “disgusting.”
“I’m just saying these are decisions that you really, really don’t want to ever have to make,” he said. “It’s a terrible decision to have to make.”
