Debt default would make Lehman chapter ‘seem like a stroll within the park’
WASHINGTON — If Congress can’t agree to a debt ceiling fix, 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 world’s financial system because of that stability, and changing that assumption could create a far-reaching domino effect that touches everything from overnight repo transactions to home mortgage prices.
The United States stared down the barrel of debt default during the Obama administration in 2011, but averted complete disaster with just days to spare. Still, the standoff hit markets, and led to a downgrade of U.S. debt by S&P Global, giving the financial world a taste of what could happen with this go-around.
And the risk of brinkmanship leading to an actual default is substantially higher this time, experts agree. The conservative Republican holdouts who fought Rep. Ken McCarthy’s bid to be House speaker have little consensus on what they want out of debt ceiling negotiations with President Biden and Democratic lawmakers, and it’s unlikely that McCarthy has the political sway to keep them in line for a vote.
House Speaker Kevin McCarthy, R-Calif., faces a difficult challenge in determining what his fractious caucus would seek in exchange for raising the debt ceiling. Failing to raise the debt ceiling would lead to unprecedented financial turmoil, experts agree.
Even Wall Street — which has become increasingly tolerant of Washington’s antics since the near-crisis in 2011 — is beginning to take notice. JPMorgan CEO Jamie Dimon said last week that the creditworthiness of the United States should be “sacrosanct,” and that questioning it “should never happen,” while Goldman Sachs economists in a recent note said that the debt ceiling is “going to be a problem.”
“Most large financial institutions feel like they need to engage in contingency planning on the assumption that you can’t really know if brinkmanship will be resolved this time around,” said David Portilla, head of the bank regulatory practice at Cravath, Swaine & Moore.
The exact consequences of a debt default — which wouldn’t happen until the country is unable to pay its bills on a so-called “X-date” sometime this summer — are murky to both forecasters and the Treasury Department. It’s an untested theory, since the United States has never intentionally defaulted on its debt before.
“Bank holding companies and the markets in general tend to assume that treasury securities are risk-free with relatively understood market behavior and volatility; if those assumptions prove incorrect, there could be significant consequences that are hard to fully know in detail in advance,” Portilla said.
But there is little question that a default would be disastrous for financial firms and for financial stability writ large.
“I think from the layman’s view of it, Treasury defaulting on its debt payments would make the Lehman bankruptcy look like a walk in the park on a sunny day,” said Ed Groshans, senior research and policy analyst at Compass Point Research & Trading.
Should the Treasury Department be unable to pay its loans, investors would demand much higher rates in the future to loan money to the government. That could lead to a spiral, where it becomes more and more expensive for the government to borrow money, and Congress would have to raise the debt ceiling at an even faster clip in the future.
Treasury markets are another big concern. In a repurchase — or repo — agreement, a firm such as a broker-dealer may need cash to finance its operations. They can offer a Treasury security to another party in exchange for cash with the agreement that the original broker-dealer will repurchase the Treasury security in the future with some nominal interest markup.
The current expectation is that a repo agreement can “roll” overnight, which means that if a broker-dealer repos out Treasury securities to raise cash for its own financing needs, and tomorrow repurchases them, they can do the same thing again. Essentially, they use short-term financing to fund long-term assets.
If people believe that Treasuries are going to default, those Treasuries are no longer desirable collateral. Fees for repo transactions could rise, or there could be a big shift in how broker-dealers find short-term financing.
“Treasuries are generally seen as essentially risk-free investments when they’re held as a placeholder before capital is deployed elsewhere,” Portilla said. “That assumption not being true could be destabilizing.”
Deposits at banks could also be hugely affected. If, suddenly, investors decided that Treasuries were no longer risk-free, they would likely seek out non-risk-bearing investments, and banks could see an inflow of deposits. This would be a roughly similar situation as March 2020, when the Treasury markets nearly ground to a halt and bank deposits rose precipitously.
While this would increase some business at banks, which have recently struggled to attract deposits, it would come as the Federal Deposit Insurance Corp. has said it’s worried about keeping the Deposit Insurance Fund to the statutory minimum. So a sudden influx of deposits could actually pose a financial stability risk if the FDIC doesn’t have enough in its fund to bail out failed banks, especially during a time of economic stress.
Even home borrowing rates and energy prices would feel the sting, said Groshans.
The mortgage market is broadly based on the ten-year Treasury yields, he said, and generally the higher that 10-year Treasury rates go, the higher that home mortgage rates will climb. That’s true in reverse, as well: Lower yields on 10-year Treasury notes translate into lower mortgage interest rates for homebuyers.
“If people get nervous and they think the Treasuries are going to default and they sell it, the yield on those Treasuries will rise,” Groshans said. “If we use the current spread, and if people pull out of Treasuries, I think we’re looking at mortgage rates closer to 10%.”
It would also result in simply less capital in the financial markets, Groshans said. Treasuries have typically served as collateral, and making that less stable would make it more expensive to fund other financial instruments and investments.
“Whoever supplied me with that collateral, I would say either take that collateral back or I’m going to do a margin call,” Groshans said. “You could start to see that, liquidity that’s in the system could get called back from those margin calls and there would be less capital sloshing around in the system, so less investment in general.”
The Fed’s new moral hazard
Initially, containing the fallout of a debt default would fall to the Federal Reserve. In 2011, Fed officials — including now-Treasury Secretary Janet Yellen — discussed the possibility, and the central bank’s options in the event of a default.
Specifically, the officials discussed purchasing defaulted Treasury bonds. This could calm the fears of bondholders and keep markets functioning until the Treasury is able to resume payments.
But that’s not likely to happen, experts say.
“Frankly, I think they’d do the platinum coin before they did that,” said Lou Crandall, chief economist at Wrightson ICAP. “I’m not even sure that’s legal.”
For one, it would present the Fed with another moral- hazard predicament, 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 liquidity to money funds, as suggested in the memo, without generating substantial moral hazard would be very difficult,” an official said during the 2011 meeting.
Fed Chair Jerome Powell, during another period of debt ceiling uncertainty in 2013, called the idea of buying out defaulted Treasury bonds “loathsome.”
“I’m just saying that these are decisions you really, really don’t ever want to have to make,” he said. “It’s a terrible decision to have to make.”