Tuesday, May 10, 2011

Countdown to Default

Sometime in mid-May, the United States will hit the debt ceiling ($14.3 trillion) which is the legal limit that the country can borrow without congressional approval. If the ceiling isn't raised, the US will default on its debt and the government will begin to shut down. But that appears to be less likely now than it was a week ago because Treasury Secretary Timothy Geithner has implemented a plan that will pay off bondholders and keep the government operating until early August. Geithner's accounting maneuvers are designed to give the Obama administration and congress a little more time to hammer out the details on a final budget deal. But that's not going to be easy, because Democrats and Republicans are still far apart on the issue of spending cuts, and neither party is willing to give ground. And that's why Wall Street is so worried, because if a settlement isn't reached soon, the uncertainty is liable to roil markets and send stocks plunging.

The conservative Republican Study Committee is calling for "immediate spending cuts, spending caps at about 18 percent of GDP and a balanced-budget amendment similar to the plan unveiled by Senate Republicans in March." (Washington Post) That's not the kind of "compromise" that the Obama team is looking for, nor will the Dems agree to slash spending and risk a double dip recession just to placate GOP deficit hawks. That's a non-starter. So, the standoff will probably drag for a while longer while the looming August 2 deadline gets closer and closer. If negotiations break-down and policymakers aren't able to reconcile their differences by early August, then the big steel door on the Treasury vault will slam shut, government payments will stop, and the United States of America will default.

No one expects that to happen. The US has never defaulted on its debt and it's not going to now. But, guess what, it really doesn't matter, because by the time congress agrees to a deal, the damage will have already been done. You see, foreign banks and financial institutions don't base their investment decisions on what actually happens, but what they "think" will happen. So, if the political stalemate continues, investors will get increasingly nervous and move their money out of US Treasuries and into something else. And, that WILL happen because, every day that goes by, the uncertainty builds and investors grow more apprehensive.

Here's an excerpt from an article in The Economist which explains what would happen if congress doesn't get it's act together and pass a budget before time runs out:

"Even a brief default on Treasury debt would be unprecedented, with widespread systemic ramifications. Would banks around the world have to classify Treasury holdings as non-performing? Would money-market mutual funds break the buck? Would all federal entities lose their AAA-credit rating? Would the Federal Deposit Insurance Corporation's ability to backstop the nation's banks come into question? Would foreign central banks start to shift out of dollars?....

The consequences of defaulting on other obligations should not be minimized, either. The federal government now has to borrow about 40 cents of every dollar it spends. A prolonged inability to meet 40% of its obligations would sow economic disarray, trigger litigation, and eventually raise doubts about its ability to meet any obligations." ("The debt ceiling and default", The Economist)

So, while the public has been focused on Bin Laden, America's debt ceiling day of reckoning has been drawing ever closer. If congress fails to make a course correction fast, the consequences could be dire. That's according to Matthew E. Zames, managing director at JPMorgan Chase and the chairman of the Treasury Borrowing Advisory Committee. Zanes send a letter to Geithner a few weeks ago warning of the danger the country faces if the situation isn't resolved pronto. Here's an excerpt from the letter:

Dear Mr. Secretary:

"As Chairman of the Treasury Borrowing Advisory Committee, I am writing to express my concerns regarding the urgent need to increase the statutory debt limit. A considerable degree of uncertainty already exists among market participants given the severe and long-lasting impact that even a technical default would have on the U.S. economy. Any delay in making an interest or principal payment by Treasury even for a very short period of time would put the U.S. Treasury and overall financial markets in uncharted territory, and could trigger another catastrophic financial crisis. It is impossible to know the full impact of such a crisis on overall economic growth and on Treasury's financing costs. However, the lessons from the recent crisis suggest that several damaging consequences will likely result, ultimately raising Treasury's long-term funding costs and increasing the burden on the American taxpayer."
Many people think that Zanes warning is just another example of Wall Street crying "Wolf", like when Henry Paulson told congress in 2008 that the economy would implode if the banks weren't given $700 billion immediately. But, while Zanes may be exaggerating, there's a lot of truth in what he says. There's no doubt that bondholders will get nervous, yields will rise, and long-term funding costs will go up. That's a done-deal. But will it really "trigger another catastrophic financial crisis"? Here's what Zanes says:

"First, foreign investors, who hold nearly half of outstanding Treasury debt, could reduce their purchases of Treasuries on a permanent basis, and potentially even sell some of their existing holdings.....

Second, a default by the U.S. Treasury, or even an extended delay in raising the debt ceiling, could lead to a downgrade of the U.S. sovereign credit rating......

Third, the financial crisis.... could trigger a run on money market funds, as was the case in September 2008 after the Lehman failure....

Fourth, a Treasury default could severely disrupt the $4 trillion Treasury financing market, which could sharply raise borrowing rates for some market participants and possibly lead to another acute deleveraging event....

Fifth, the rise in borrowing costs and contraction of credit that would occur as a result of this deleveraging event would have damaging consequences for the still-fragile recovery of our economy....."
Is he exaggerating?

Maybe, but maybe not. No one really knows for sure. But there's a good chance that foreign investors will reduce their purchases of Treasuries, which means that borrowing costs will go up and credit will get tighter. A default would also lead to a downgrade on U.S. debt, severely disrupting the $4 trillion Treasury financing market. And that could easily trigger another run on the shadow banking system. In fact, it's impossible to imagine that it wouldn't start another bank run.

So, it's likely that all of these things will happen--to one degree or another--if congress doesn't find a way to reach a compromise. But most importantly, as Zanes points out, this whole cascade of horrific events could take place whether the US defaults or not; a mere delay in raising the debt ceiling could light the fuse that sends yields into the stratosphere while the dollar goes off a cliff. It's no joke.

But what's missing in Zanes letter is any mention of why the country is so deeply in the red to begin with. It has nothing to do with social programs or profligate "entitlement" spending. That's a load of malarkey. It's all connected to the gigantic bailouts that were given to the nation's biggest banks after they blew up the financial system. Here's a clip from an article titled "Can't blame economic policy on Osama" by ex-Goldman Sachs analyst Nomi Prins that helps to explain what's really going on:

".... what all these numbers show is that; public debt has nearly doubled since before the big bailout, while intragovernmental debt has increased just 15%. Some (like Geithner, Bernanke, etc.) may argue that this balloon in public debt was required to save our economy, though there's little evidence of it doing anything but cheaply floating our financial system, not least because nearly half of the additional $4.4 trillion of public debt that was created is stashed at the Fed as either excess reserves, QE1, or QE2....

No one on the Hill will question the true why behind the debt – because it would lead back to that mammoth fuchsia elephant - we, the elected and appointed, screwed the country to support the power banks, and we'd do it again, in fact, we already are." ("Can't blame economic policy on Osama", Nomi Prins, nomiprins.com)
The reason the country is facing widening deficits and mountainous debts, is because we've been handing out trillions of dollars to thieving banksters who should be in in the jail. Period. Even so, that doesn't address the problem at hand, which is raising the debt ceiling. On that point, the markets are already in the process of making adjustments that might have grave long-range implications for the US. For example, Geithner has slashed the issuance of new Treasury bills to $142 billion instead of the estimated $298 billion. What difference does that make?

Well, it just so happens that there's a dearth of high quality collateral in the repo market at present, and this just makes the situation worse. (I realize that this all sounds like "inside baseball", but stick with me for a minute and you won't be disappointed.)

Here's the scoop: The experts believe that investors might start looking for "permanent alternatives" to US Treasuries in their repo trades. In fact, that appears to be the pattern already. According to RBC Capital Markets' Michael Cloherty:

"...we think the migration from bills to other cash investment alternatives will be more rapid than what we saw in 1997 – 2001. Some of that loss will be from changes in investment guidelines, some will be from managers simply becoming more comfortable with different issuers/different currencies/etc, and some will be from end users pulling cash away from Treasury‐only funds." ("Honey, I broke the repo market, FT Alphaville)

Okay, so investors move from US Treasuries to some other "risk free" financial asset; why does that matter?

It matters because the bond market supports the dollar, and the dollar is the foundation upon which the empire is built. When UST's lose their special role as the benchmark for pricing financial assets, the whole unipolar system will begin to teeter. In other words, attracting foreign capital to UST's is a lot more important to the maintenance of the US imperium, than winning wars in Iraq or Afghanistan. A flight from UST's will accelerate America's decline and constrain its ability to project power around the world.

So, we shouldn't underestimate the significance of the debt ceiling drama. The stakes couldn't be higher. If congress botches the budget deal, we're likely to see major dislocations in the world's largest and most liquid market, USTs. Here's an excerpt from an article by Kevin Warsh, a former member of the Board of Governors at the Fed, who explains what will happen if confidence in USTs begins to wane:

"The Fed's increased presence in the market for long-term Treasury securities also poses nontrivial risks. The Treasury market is special. It plays a unique role in the global financial system. It is a corollary to the dollar's role as the world's reserve currency. The prices assigned to Treasury securities--the risk-free rate--are the foundation from which the price of virtually every asset in the world is calculated. As the Fed's balance sheet expands, it becomes more of a price maker than a price taker in the Treasury market. And if market participants come to doubt these prices--or their reliance on these prices proves fleeting--risk premiums across asset classes and geographies could move unexpectedly. The shock that hit the financial markets in 2008 upon the imminent failures of Fannie Mae and Freddie Mac gives some indication of the harm that can be done when assets perceived to be relatively riskless turn out not to be." ("The New Malaise", Kevin Warsh, Wall Street Journal)
Warsh has every reason to be concerned, congress is unwisely putting the very credibility of the United States on the line. Remember, the US does not keep underground bunkers loaded with gold bullion to meet its obligations. It depends on the confidence of foreign central banks and investors to maintain the illusion of solvency. Once that confidence runs out, then... POOF... the game is over. The US will be unable to maintain its preeminent role in the global order. The empire will wither.

Is that such a bad thing? For those who think that "unitary global rule" is a failed experiment, the peaceful erosion of US power is the best possible outcome. The longer congress drags its feet, the better it is for everyone.

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