What happens if the United States defaults on its debt?

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As Washington draws closer to a possible midnight government shutdown on Thursday, here’s why the country’s debt ceiling status could cause more concern in financial markets.

September 30 marks the end of the federal government’s fiscal year and the deadline for Congress to pass a fundraising measure. The debt ceiling, which is the amount of money lawmakers allow the Treasury Department to borrow, must be suspended or raised by mid-October, or the United States will likely default on its debt.

Importantly, no one knows for sure when the US Treasury will run out of money to pay its bills, including bondholders, let alone what would happen next. U.S. sovereign debt has generally been viewed as the safest and most liquid to hold in the world, and all manner of financial market products and processes have been linked to the orderly functioning of the nearly $ 21 trillion treasury market. .

Yet after a few years in reverse in which the previously unthinkable has become reality, some professionals in Washington and Wall Street are bracing for the worst-case scenario.

“I see this as extremely slim chance, although with all the staging the possibility has been increased,” said Ben Koltun, director of research for DC-based Beacon Policy Advisors. “If that happens, it turns a fabricated political crisis into an economic crisis. The full faith and credit of the United States would no longer be full. “

The deadlock on Capitol Hill right now is over $ 3.5 trillion in spending.

Is the United States going to run out of money?

In a research note released on September 22, Barclays analyst Joseph Abate noted that there is currently additional uncertainty about the debt ceiling, as it coincides with a funding plan that Congress must pass. In addition, the changes brought about by the pandemic have made it much more difficult to assess the status of expected payments and receipts from the Treasury Department.

Barclays’ best estimate for “date X,” or when the Treasury will run out of money to pay bills, is October 29, but, Abate wrote, “the confidence interval around date X is likely to remain enough. large”. Moody’s Analytics chief economist Mark Zandi has set the fateful day for October 20, while Beacon’s Koltun believes the markets will start to fret in mid-October.

Read: America runs out of cash between October 15 and November 4, as debt limit drama continues

The very idea of ​​an American default remains so incongruous that the reaction of financial markets is not the only unknown. The current confrontation in Washington has also raised big questions about the infrastructure of financial systems. It’s a bit like the year 2000 – no one knows how computers will react.

“We don’t believe and the market doesn’t believe this is a likely scenario,” said Rob Toomey, SIFMA Managing Director, Capital Markets and Associate General Counsel. “But that would be a real problematic scenario for the system in general and operations and settlement in particular.”

Plumbing problems

SIFMA, the Securities Industry and Financial Markets Association, is the industry association that deals with the trading and settlement mechanisms of securities such as sovereign bonds. The group worked with financial infrastructure providers, including Fedwire and FICC, to try and come up with some sort of playbook. For now, two scenarios are possible:

If the Treasury Department knows it will miss a payment, it would ideally announce it at least a day in advance. This would change the maturity dates of the bonds in question: a Monday maturity date would be changed to Tuesday, a Tuesday maturity date would be changed to Wednesday, and so on. These revisions would be made day after day.

While this looks relatively tidy, it still leaves a lot of unknowns. On the one hand, this could split the bond and treasury bill market into those that balance normally and those whose maturity dates are being massaged, SIFMA told MarketWatch. This means great uncertainty about prices and what it means for all downstream securities indexed to Treasury rates.

In a second scenario, which according to SIFMA would be very remote, the Treasury cannot or does not give any advance warning in the event of non-payment, and it just happens. It would be much more chaotic, “a real problematic scenario”, as SIFMA puts it.

Oddly enough, the titles in question would probably simply disappear from the system. That’s because if a bond is supposed to mature – and be paid – on a particular day, the system assumes it has. “It just illustrates the fact that the system was not designed for this,” notes SIFMA.

If this happens, there would be a holder registered for the debt the day before the due date, who would be entitled to be paid. However, it is also likely that the Treasury will pay additional interest to make the bondholder whole.

Many analysts, including Zandi, think it’s very likely that some sort of financial market panic – think of the day in 2008 when Congress initially failed to pass Troubled Asset Relief Program legislation intended to deal with the financial crisis – would end any of the scenarios SIFMA is considering before they happen, or a few minutes after midnight on the day they happen.

But as Koltun put it, “Even if only for a moment, the credibility that is lost, could be a permanent rise in Treasury rates TMUBMUSD10Y,
1.481%
and this has cascading effects on financial markets around the world. Every time the political chicken game ends before there is any real flaw. If it really happens, it becomes, it’s real, and it fundamentally shakes the heart of full faith and the promise of credit. “

The “chicken game” can also already hurt the economy. The last two times Congress nearly failed to raise the debt limit, in 2011 and 2013, according to Moody’s Analytics, “the heightened uncertainty at the time reduced business investment and hiring and weighed heavily. on GDP growth. Without this uncertainty, in mid-2015, real GDP would have been $ 180 billion higher, or more than 1%; there would have been 1.2 million additional jobs; and the unemployment rate would have been
0.7 percentage point lower.

The uncertainty that reigned in the treasury market in 2013 cost taxpayers between $ 40 million and $ 70 million, Barclay estimates.

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