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A U.S. Default Is the Ultimate Systemic Risk

Just this week, a number of GOP Congressmen at the center of the debt-ceiling showdown were quoted as thinking a default by the US government might not be a significant event for the economy.

That perspective is dangerous and shows a complete lack of understanding of the basics of financial markets, panic and contagion, particularly when the latest crisis places us squarely in uncharted territory.

This country has a long, painful history with asset bubbles and associated crashes. A true default by the U.S. government, however, would be unprecedented and the importance of the U.S. dollar as the world’s reserve currency, together with heavy reliance of financial markets on U.S. Treasuries, portends a financial maelstrom rather than a minor event as some GOP legislators predict.

A U.S. default has a reasonable likelihood of sparking a liquidity crisis on par with that of 2008, leading to recession in the U.S. and abroad. Although these are uncertain outcomes, even a small chance of this happening should be a sufficient deterrent against allowing the debt ceiling limit to lapse for anyone knowledgeable of the way financial markets work.

However, if this argument is insufficient to sway some perspectives in both parties, then consider how three critical markets that contributed to the last crisis and continue to pose substantial risk to the economy in the event of a U.S. default would perform under this scenario.

Money market mutual funds wound up getting a black eye during the financial crisis of 2008-2009 with the Reserve Primary Fund falling below a net asset value of $1 ("breaking the buck") which threatened to unravel this market. Reforming this market has been painfully slow. Under normal circumstances, the money funds’ large share of investments in U.S. Treasuries and related securities would pose a source of strength. But in the present situation, their position in Treasuries presents the possibility of large redemptions leading up to a default event and afterward. Moreover, money fund managers face significant challenges in how they would handle defaulted Treasuries sitting in their portfolios. And for a market totaling $1.75 trillion in retail and institutional funds, tremors would have major repercussions for investors and other markets.  It is nearly impossible to predict the "animal spirits" pervading financial markets, but underestimating investor behavior and redemptions in a crisis risks the economic safety of this country.  

One of these markets that could be affected by money fund dislocation is asset-backed commercial paper. During the last crisis the Federal Reserve had to step in with the Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility to help prop up the ABCP market in light of a selloff of these assets by money funds. In the case of a U.S. default, credit spreads would rise and liquidity would dry up quickly as benchmark rates rose for interbank borrowing. The ability for corporations and financial institutions to roll over short-term commercial paper would come under stress as companies reevaluate their risk exposures to counterparties.

Another market lying in the shadows where significant risk exists in a U.S. default scenario is that of repurchase agreements. This short-term market, where banks borrow and lend to each other, is heavily dependent on U.S. Treasury instruments as pledged collateral. The Federal Reserve Bank of New York, for example, reported that 37% of pledged collateral worth $555 billion in tri-party repo agreements were in Treasuries.

In light of a U.S. default it is hard to imagine how repo markets would not be disrupted given the heavy reliance on Treasuries and the uncertain treatment of defaulted securities as eligible collateral in repo agreements.

Compounding matters in these shadow banking markets, a U.S. default and associated rating downgrade would wipe out a massive amount of on-balance sheet value not only for commercial banks and investment portfolios but also for the Federal Reserve. While the Fed doesn’t have to mark its balance sheet to market, banks will feel the effect in falling asset values, which will also directly sap the confidence of investors and of consumers as their wealth erodes. Both outcomes would hurt the economy as two major drivers – credit availability and consumer confidence – fade fast.

Default by the U.S. government is the ultimate systemic risk. We face the real possibility that Congress (which passed the Dodd-Frank Act in 2010 in part to correct perceived deficiencies in financial markets) and the Administration sometime in the next few weeks will trigger a systemic risk event every bit as harmful as the financial crisis of 2008-2009. Back then we had little ability to avoid a crisis. A U.S. default crisis is avoidable if Congress and the Administration act now.  

Those in Congress that believe the market’s relatively muted response to their dysfunction so far is evidence that a default would not be disruptive need to keep in mind that Lehman bonds traded relatively well in the week leading up to the investment bank’s bankruptcy. Demagoguery in whatever form it comes is dangerous to us all and even more so when politicians are ignorant of the financial consequences of inaction in the name of ideology.

Clifford Rossi is the Professor-of-the-Practice at the Robert H. Smith School of Business at the University of Maryland.


(4) Comments



Comments (4)
I agree that lack of education is a large part of the problem. Republicans have done a poor job of educating the voting public about the nature of the situation. But even common households can understand income, expenses and debt. I wish we did a better job of explaining that approximately $5 trillion in revenue with approximately $6 trillion in spending, creates approximately a $1 trillion deficit, and this shortage must be borrowed. Our annual interest payment of approximately $450 billion must be entirely borrowed if we continue our current level of spending. Common people know this math doesn't work in their personal lives and there are consequences. Other countries have shown us that there can also be consequences for nations. But I'm not sure we have admitted that to ourselves yet, even though we are currently advertising it to the world. Our nation is strong, and we can overcome this. But we have to take the right steps now.
Posted by Small Bank President | Tuesday, October 15 2013 at 1:05PM ET
It's an inconvenient truth, but Congress is as financially illiterate as the average American consumer, having had the same, inadequate economic education as most of us, and not having educated themselves beyond their hueristically formed beliefs. Even small bankers over-simplify with anecdotes that conveniently couple with that emotional bogeyman, "socialism", as if America is not a society, but a land of stray cats, rugged individuals and corporate citizens. From the tax code to Medicare, our society's economic education and attendant fiscal beliefs are diverse, thorny, complicated and (obviously) no longer effective. Perhaps we need to do some hard work for a change, get financially educated as a nation, and then start making some collaborative and rational decisions about our society, economy and perhaps even our political system.
Posted by mdillon | Tuesday, October 15 2013 at 11:02AM ET
This is an absolute and complete distortion of the position of the quoted lawmakers. The fault is also with the NYT and its headline which attempted to attract attention. The clear case made by Senator Paul, in this article and on the weekend talking head shows, is that default on our public debt would occur if we don't pay the interest (principal is rolled over). The government brings in through revenues about 12 times as much in revenue as the required interest on the debt service. Therefore it is ridiculous to talk about 'default.'
Posted by vernmckinley | Friday, October 11 2013 at 12:35PM ET
Hopefully, this conversation of increasing the "debt" ceiling to pay our "debt" will gravitate towards the next logical conversation of... "We can't pay our debts with income". We have a saying around the bank that "you can't borrow your way out of debt", and that holds true for consumers and governments. People in Greece were shocked when temporary government shut downs turned into permanent shut downs through Austerity Measures. Democrats don't seem to think that the US can suffer the same consequences of insolvency, but I would encourage them to study the chart of historical US debt compared to Greece. When you can't pay your debts with income, you're insolvent. The strongest US economy we have ever had could not pay the interest on our current debt. Balancing the budget, cutting programs/spending and increasing taxes is the only chance this country has to keep its identity, and avoid socialism.
Posted by Small Bank President | Friday, October 11 2013 at 12:35PM ET
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