Treasury Default Firewall Hatched in 2011 Crisis: Credit Markets

The groundwork for preventing a U.S. Treasury default from causing a cataclysmic breakdown of the plumbing of the global financial system was laid after the last debt-ceiling crisis in 2011 -- and is still a work in progress.

The Treasury Market Practices Group, the government-debt markets watchdog that’s sponsored by the Federal Reserve Bank of New York, outlined steps last year that would include manually changing the maturity dates of securities that are processed through the central bank’s Fedwire, its electronic service that transfers securities and payments. That would help enable systems to handle debt with delayed payments.

Even with two years of preparations, the financial industry is racing against an Oct. 17 deadline when the government says it runs out of its borrowing authority. Kenneth Bentsen, the president of the Securities Industry and Financial Markets Association, told Congress this week that Wall Street is still at work, particularly in the $5 trillion market for repurchase agreements, or repos, a form of secured, short-term borrowing that is frequently backed by Treasuries.

“Since filing our written testimony just yesterday, market participants have continued to meet and review enhancements that might -- that could -- mitigate operational risks that have been identified, particularly in the repo market,” Bentsen said Oct. 10 before a Senate panel.

‘Shadow Banking’

Repos are part of the non-bank, or “shadow banking,” sector. Banks and investment firms use them to help finance investments in Treasuries, corporate bonds and mortgage-backed securities. Money-market funds such as those used by individuals to park cash and savings, are a major provider of repo financing.

The repo market is “in many important ways the lubricant of a modern financial system,” Fed Governor Daniel Tarullo said in a speech yesterday in Washington. “But, like many lubricants, they can be accelerants when things get hot.”

The TMPG, which includes representatives from Morgan Stanley and BlackRock Inc., also proposed that principal payments for securities with delayed maturities be paid to the final holder of the debt, according to minutes of the group’s June 2012 meeting. Eventual interest payments would be made to the security’s holder on the originally scheduled date.

The $11.6 trillion of marketable debt outstanding is 23 times the $517 billion that Lehman Brothers Holdings Inc. owed when it filed for bankruptcy in September 2008, causing the worst financial crisis since the Great Depression.

Contingency Plans

Markets may have received more time to prepare yesterday when the White House endorsed a short debt-limit increase with no policy conditions attached, signaling potential support for House Republicans’ plan for a month-long reprieve from a default.

The TMPG discussed contingency plans throughout last year after disruptions in the markets occurred before a looming debt-ceiling deadline in August 2011, sending repo rates to a two-year high. Last month, the group saw that its contingency plan would “only mitigate, not eliminate” potential malfunctions, according to minutes from a Sept. 25 meeting.

If Wall Street’s planning fails to keep markets functioning, the Fed may be forced to intervene, as it did after Lehman collapsed, according to Nomura Holdings Inc.

“The Fed would need to make sure things don’t unravel,” said George Goncalves, the head of interest-rate strategy at Nomura, one of the 21 primary dealers obligated to bid at government auctions. “This appears possible, given what the Fed has done in past crises.”

Fed Intervention

Not all Treasuries would be in default if the government starts missing payments, only those maturing or with coupon payments, according to JPMorgan Chase & Co. About $120 billion in bills are scheduled to mature on Oct. 17 and an additional $93 billion on Oct. 24, according to Sifma. About $1.8 trillion of Treasuries owned by private investors have interest payments in late October or early November, according to Nomura.

The Fed’s options include temporarily swapping some of the Treasuries it holds for defaulted debt, buying the notes outright, or cutting the rates that at which it lends to provide broader stimulus, according to Nomura.

“The Fed can do an awful lot to provide money market liquidity, ease repo market financing issues and, in the extreme, extricate the offending securities from the financial system,” Dominic Konstam, the head of global interest-rate research at Deutsche Bank AG in New York, wrote in a note.

‘Hot Potato’

The main type of repo financing known as the general collateral market, in which lenders don’t know which notes will back their loans, may be impaired on concern that they will be assigned defaulted debt, according to Nomura.

“It’s like the hot potato,” said Scott Skyrm, the former head of repo and money markets for Newedge USA LLC and author of the book “The Money Noose: Jon Corzine and the Collapse of MF Global.” “Nobody wants to get stuck with the security that is technically defaulted for a period of time.”

The nature of different money fund managers’ repo agreements vary, with many contracts currently not willing to accept defaulted Treasuries, said Deborah Cunningham, the head of money market funds at Pittsburgh-based Federated Investors Inc., the third-biggest U.S. money fund manager.

“In most instances the collateral approved for repo counterparty backing has a requirement of not being in default,” she said in a telephone interview. “If we thought there was going to be a default, we’d be working on those contracts right now. And we are not.”

Collateral Pledge

Depending on timing during a day and the advance notice of a default, some Treasuries may no longer be able to be moved between market participants at all, Bentsen said yesterday after the congressional hearing.

“If that security is not transferable then it can’t be pledged for collateral for repo,” he said. “It could have to be replaced. That becomes a liquidity problem.”

A delay in payments by the Treasury on its obligations could be deemed a technical default, because the government would have the ability to pay, yet would choose not to, according to JPMorgan. In such a case, prices of Treasuries that mature or have coupon payments due during that time would likely undergo the greatest negative reaction.

Accurate Pricing

One-month bill yields and rates in the market for repurchase agreements using Treasuries as collateral have climbed. Rates on Treasury bills due on Oct. 17 traded as high as 0.505 percent yesterday before ending the day at 0.305 percent, according to Bloomberg Bond Trader prices. That’s up from 0.122 percent at the end of last week and 0.025 percent on Sept. 30. The yield was at 0.265 percent as of 10:55 a.m. in New York.

Another concern is whether clearing banks can provide accurate pricing for Treasuries serving as repo collateral, said James Tabacchi, chief executive officer of New York-based South Street Securities LLC, which manages an $18 billion matched repo book. Valuations are needed to see how much collateral is required in excess of loan sizes and determine margin calls.

“They’re working on it, but I don’t know if they have an answer yet,” he said.

The Depository Trust & Clearing Corp., whose subsidiaries last year processed $1.6 quadrillion in securities transactions, “continues to monitor overall market activity, with a particular focus on the Treasury market,” Judy Inosanto, a spokeswoman, said yesterday in an e-mail.

Officials “are assessing if we will need to make any types of adjustments in our valuations of securities required for collateral in our clearing fund,” she said. “At this point, this is still a precautionary exercise and our approach towards haircuts on collateral remains unchanged.”

Damage Confidence

While a delay of payments on some securities may be technically manageable for the market, the event will still damage global investors’ confidence in Treasuries, said Darrell Duffie, a finance professor at Stanford University’s Graduate School of Business.

“From the viewpoint of the safe-haven status of U.S. Treasuries it would be very negative,” Duffie said. “It would chip away at that in a manner that is incremental and that would be hard to get back. It takes a long time to recover the view that U.S. Treasuries would never default, even in a technical way.”

Another concern is whether the Fed, which is currently buying $85 billion of Treasuries and mortgage bonds monthly, would allow Treasuries with delayed payments to be used in open market operations overall, according to the TMPG meeting minutes. Market participants also want to know whether the Fed will accept defaulted Treasuries as collateral at its discount window, the Fed’s emergency loan facility.

‘Unpleasant Experience’

The central bank hasn’t given guidance on its plans. Jack Gutt, a spokesman for the New York Fed, the branch of the U.S. central bank that implements monetary policy, declined to comment.

The Fed will probably continue accepting technically defaulted Treasuries as collateral at the Discount Window as the Federal Reserve Act doesn’t explicitly prohibit such actions, Duffie said. The act also doesn’t prevent the central bank from purchasing defaulted Treasuries through its open market operations.

“Investors believe that this is going to be a very unpleasant experience but it should be short-lived, or only temporary,” said John Lonski, chief economist at Moody’s Capital Markets Group in New York. “It would be very difficult to be fully prepared for it.”

Default Swaps

Elsewhere in credit markets, the cost of protecting corporate debt from default in the U.S. decreased, with the Markit CDX North American Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, declining 0.9 basis point to a mid-price of 77.7 basis points as of 10:57 a.m. in New York, according to prices compiled by Bloomberg.

The measure typically falls as investor confidence improves and rises as it deteriorates. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, rose 0.45 basis point to 13.83 basis points as of 10:57 a.m. in New York. The gauge widens when investors seek the perceived safety of government securities and narrows when they favor assets such as company debentures.

The Bloomberg Global Investment Grade Corporate Bond Index has lost 0.13 percent this month, bringing losses for the year to 1.57 percent.

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