Disruptions in the debt markets from a U.S. government default would be minimized as long as lawmakers gave enough advance notice of which securities would be affected.
Treasury Secretary Jacob J. Lew has said that the accounting moves the U.S. has been using since May to stay below the nation’s $16.7 trillion debt limit will expire on Oct. 17. On that day, the Treasury has $120 billion of bills maturing, followed by $93 billion in more of its shortest maturity debt instruments due on Oct. 24.
A default may not disrupt markets as long as the U.S. alerted traders the night before a payment was due that it was probably going to default, giving the Federal Reserve’s Fedwire, an electronic service that transfers securities and payments, enough time to adjust its programs and allow the defaulted debt to be “transferable,” according to JPMorgan Chase & Co. That would allow them to continue to be used as collateral in repo markets.
“Treasury can, in principle, delay coupon or principal payment dates,” wrote Alex Roever, the head of U.S. interest-rate strategy at JPMorgan Chase & Co. in Chicago. “If Treasury announces its intention to postpone a payment date in advance, the day before the payment is due, the security will remain in Fedwire, and would therefore be transferable.”
The Securities Industry and Financial Markets Association, or Sifma, in a statement this month said if the Treasury were to delay payments on debt it would extend the payment date of the securities one day at a time. The Treasury Market Practice Group, an industry organization sponsored by the Federal Reserve Bank of New York that advises on transactions in U.S. securities, said last month contingency planning developed since the 2011 debt-limit crisis would mitigate yet not eliminate the operational risk posed by government-debt payment delays.
Some clearing firms are preparing for a default, with Citigroup Inc. and State Street Corp. discussing ways to limit the use of short-term Treasury bills as collateral in coming weeks, the Wall Street Journal reported on its website yesterday, citing people familiar with the matter. Citigroup told some clients it would prefer not to take U.S. government debt maturing Oct. 24 or Oct. 31 as security for transactions, the newspaper reported.
A Treasury default would be deemed technical because it would be the result of the government’s unwillingness, not its ability, to pay. In a technical default, only the prices of Treasury bonds that mature or have coupon payments would likely fall, according to the analysts. Money-market funds wouldn’t be forced to sell government bonds, and the Fed probably would continue accepting them as collateral for emergency cash.
If Congress doesn’t raise the borrowing limit, the agency will be confronted with a decision to either prioritize payments on government debt and other obligations, or to delay payments. The Treasury has said it can’t prioritize payments.
“The systems have not been set up assuming Treasuries might default,” Michael Cloherty, head of U.S. interest-rate strategy in New York at Royal Bank of Canada’s RBC Capital Markets unit, one of 21 firms that trade directly with the Fed, said during a telephone interview. “So there are problems with moving defaulted securities from one person to another, there are problems with settling those trades, there are problems with using them as collateral in the repo market.
“If the Treasury gives advance notice fairly early, like the day before, that it will default the next day, people would probably have time to tweak their systems and allow those securities to trade and settle normally,” said Cloherty, who gave “small odds” to the Treasury being able to give such advance notice.
According to the Congressional Budget Office, the Treasury receives about $7 billion daily in cash inflows. The shortfall means the government is confronted with some difficult choices on what to pay out of its daily revenue.
If there was a technical default, “there will be ways for the Treasury to calm the waters with respect to the fundamentals on the U.S. Treasury securities,” said Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business in Stanford, California. “For example, if the Treasury Department wishes to, it could come out and say that any coupon or principal payments that are currently unable to be paid will be paid with interest according to the issuance yield on these securities as soon as it is practically feasible. That would help calm the markets.”
During the 2011 debt ceiling debate, Treasury officials said delay was the most feasible of bad alternatives, according to a report written by the Treasury’s Office of the Inspector General. Under this alternative, no payment would be made until all payments due that day could be paid.
The U.S. hasn’t defaulted since 1790, when the newly formed nation deferred until 1801 interest obligations on debt it assumed from the states, according to “This Time Is Different,” a history of financial crises by Carmen Reinhart and Kenneth Rogoff.
If the Treasury gives a day’s notice on payment delays, that would also prevent the $2.6 trillion-a-day Treasury repurchase agreement market from seizing up, according to JPMorgan. The repo market, where dealers borrow cash from money market funds in post debt as collateral, has Wall Street banks finance holdings and increase leverage.
With advance notice, allowing the security to remain in Fedwire and transferable, “it could in principle be used as collateral for repo and derivatives transactions, although possibly with higher haircuts” JPMorgan’s Roever wrote in an Oct. 10 note, which was co-authored by Praveen Korapaty, Devdeep Sarkar and Bruce Sun. An increase in haircut means lenders are willing to advance less funds against the same amount of collateral offered for a repo loan.
The average rate for borrowing and lending Treasuries for one day in the repo market surged last week to 0.23 percent as money funds backed away from transactions that involved debt that might be caught up in a default. The repo rates rose from as low this year of 0.016 percent, according to a general-collateral finance repo index provided on a one-day lag by the Depository Trust & Clearing Corp.
Overnight general collateral repo for Treasuries opened today at 0.23 percent, according to ICAP Plc, the world’s largest inter-dealer broker, up from the open yesterday of 0.2 percent.
In a general-collateral repo transaction, the lender of funds is willing to accept a variety of Treasury, mortgage-backed securities or agency collateral.
Still, “with a default, even one that is technical in nature, market liquidity will likely be substantially impaired, and repo costs and haircuts on defaulted securities are likely to see a broad-based increase,” the JPMorgan strategists wrote.