Tuesday, October 1, 2013

"How a Debt-Ceiling Crisis Could Become a Financial Crisis"

Annie Lowrey @ NYTs Economix:

Come mid-October, the United States will have only $30 billion of cash on hand. On any given day, its net payments can reach as high as $60 billion. That means that unless Congress raises the debt ceiling, allowing the Treasury to issue new debt, the United States may find itself unable to make all of its payments — stiffing government contractors, or state and local governments, or even its bondholders.

Economists widely agree that such an unprecedented event would have profound effects for the markets, likely precipitating a stock-market sell-off and setting off a round of global financial turbulence. But it has always been a little unclear just how it may play out. The Treasury might announce it would be forced to delay some payments, promising to do what it could to make sure bondholders were made whole. But then what?

The team at RBC Capital Markets has put together a terrifying play-by-play for the Alphaville blog of The Financial Times. It shows how a debt-ceiling breach would translate quickly into a credit crunch and financial crisis with some disconcerting similarities to 2008. Get ready for some scary reading:
Let us be perfectly clear: crossing the debt ceiling would be catastrophic. The Treasury’s systems do not clearly mark what scheduled payments are for what reasons, so it is impractical to try to prioritize payments. And clearing systems like Fedwire do not allow defaulted securities to flow, so the system would seize. In order for the clearing systems to work, the Treasury would need to notify the market of a default almost a day before the default happened (to give everyone time to modify payments), and that is not going to happen because the Treasury will not want to declare default while Congress still has time to pass a bill. Also the Fed does not take defaulted securities as collateral at the discount window, even if those securities are still trading at par.
It continues:
While we think the probability of the debt ceiling causing a technical default in the Treasury market is near zero, nonetheless, there are likely to be market disruptions. The main issue is that the markets are not set up to trade or finance defaulted Treasuries. While many RP documents say that defaulted securities cannot be delivered as collateral, delivery systems are not set up to easily sort out which Treasuries have defaulted and which have not (there are no cross-defaults on Treasuries), so the RP markets can seize up as the debt ceiling drop-dead date approaches.
That’s pretty technical, but it boils down to this: A debt-ceiling crisis could throw sand — a whole lot of sand — into the gears of the financial system, making it impossible for market participants to tell “good” collateral from “bad” collateral. As my colleague Binyamin Appelbaum points out, that’s essentially the definition of a modern financial crisis.

What’s interesting — and disconcerting — to think about is how all the new tools the Treasury and Fed developed during and after the 2008 financial crisis will work in the event of a new crisis. The Treasury would be the source of the turbulence it would desperately be trying to stop, after all.

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