Appointed Senator Dean Heller (R-NV) sounds confident about the debt ceiling hostage situation in Washington, “Even if the Aug. 2 deadline to raise the national debt ceiling comes and goes without Republicans and Democrats reaching an agreement, U.S. Sen. Dean Heller, R-Nev., said he doesn’t think the nation will enter a default.”That’s a pretty big ‘if,'” he said. “Default means we’re not able to pay our interest (on the nation’s debt). A default would be largely detrimental and not healthy for America or Nevada, but we should be able to pay our interest.” [RGJ] Really? The story isn’t quite so simple from some other perspectives.
The Bankers
Charles Plosser, President of the Philadelphia Federal Reserve, shares Heller’s optimism up to a point, but the point is quickly reached. Plosser believes that there will be an agreement, but the Fed is preparing for the possibility of a default “just in case.” Contrary to Senator Heller’s dismissal of the problem as one of simply paying interest, the Federal Reserve “… effectively acts as the Treasury’s bank — it clears the government’s checks to everyone from social security recipients to government workers. “We are developing processes and procedures by which the Treasury communicates to us what we are going to do,” Plosser said, adding that the task was manageable. “How the Fed is going to go about clearing government checks. Which ones are going to be good? Which ones are not going to be good?” [Reuters]
There is an additional problem for bankers:
“Domestic banks would not have to classify their sizeable holdings of Treasuries as non-performing if they thought the default short-lived. But they would suffer nonetheless. Currently Treasuries represent roughly 30% of the collateral that financial institutions such as investment banks use to borrow in the $4 trillion repurchase (“repo”) market. They represent another 4-5% of the $1 trillion in collateral used in the derivatives market. A default could trigger demands by lenders like money-market funds for more or different collateral.” [The Economist]
The lower the value of the collateral, the less banks can borrow in the “repo” market, the less they can borrow, the less they can lend. Can we say Credit Crunch again?
The Bond Fund Managers
As of June 29, 2011 fund manager Jeffrey Gundlach was predicting, “…some type of polite default, at a minimum, will happen.” He expects the US to renege on some of its debt or entitlement obligations, such as by imposing a tax on the maturity of government debt or by cutting back on entitlements. “That would be a way of engineering a default in a creative way,” he said.” [AdvisorPersp]
Meanwhile Mr. Gundlach was taking his own advice, with 10% of his firm’s assets in cash, about five times the normal amount. Why? “Gundlach, the chief executive officer of Los Angeles-based DoubleLine Capital Inc., said in a telephone interview that he has 10 percent of the fund’s assets in cash, about five times what it usually holds. He views a move in the 10-year Treasury yield above 3.5 percent as a buying opportunity.” [BusWk] If DoubleLine Capital were the only money managers adopting this strategy that would be one thing, but it isn’t. Thornburg’s Limited Term U.S. Government Fund kept 9.5% of its assets in cash, about double its usual amount. Western Asset Core held some 33% of its assets in cash as of June 30, 2011. The Total Return Fund (PIMCO) has about 29% of its assets in cash. [BusWk]
If we think Wall Street hasn’t noticed what’s going on then we haven’t been paying attention, traders have picked up on the possibility of a default:
“The possibility has not gone unnoticed. Trading in credit-default swaps (CDSs) on Treasury securities has picked up and the price of protection against default, as measured by the CDS spread, has risen (see chart). One-year protection is now almost as expensive as five-year protection. This is more often seen in distressed markets where investors are pricing in an imminent default than with otherwise healthy borrowers with long-term problems.” [The Economist]
Those playing at the tables in the Wall Street Casino are busy hedging either direction. Either way, “polite” or “impolite,” they’ll earn their commissions. But, what happens if the default isn’t “polite?”
The Economists
Kenneth Rapoza explains the tricky position in which the bond funds find themselves by first defining the playing field:
“There are two things investors consider when buying government bonds. They are essentially making two bets. One bet is on the government’s ability to pay that debt within the maturity of the bond, so whether it is 10 or 30 years, investors are betting that the government will make good on its promise to service its debt and pay it in full throughout the life of the bond. The second bet is political. Investors are hoping that the government doesn’t suddenly change its political and economic system entirely and, as a result, opt out on paying bondholders.” [Forbes]
Thus, if the default is “impolite,” then the bond funds have lost on the second side of the bet. Little wonder the bond funds are sitting on cash given (1) low current yields, and (2) the prospect that the U.S. might “opt out on paying bondholders.”
Rapoza continues his analysis of the second side of the bet:
The US does have a problem, but it has something Greece never had, nor any country in the world, ever in history, for that matter: it has the world’s reserve currency. It still has AAA credit status, and debt that is backed by the taxing powers of the US government. The US Treasury Department has a lot it can do before it has to default on debt, but before it does any of those things, it needs the debt ceiling to be raised from the $14.26 trillion limit set earlier this year and then broken through in April, when the national debt ended the month at $14.28 trillion. [Forbes]
Rapoza isn’t the only one voicing concerns:
“No one knows exactly what would happen in a U.S. government debt default, but economists agreed on Wednesday that it would be best not to find out. “You cannot play games with something this serious,” Simon Johnson, former chief economist of the International Monetary Fund, said at a congressional hearing. “Other countries that have tried to play these kinds of games with the financial market usually end up getting burned.” [Reuters]
A few economists have jumped into the fray from the other direction, calling for a default in the form of some manner of useful economic emetic. However, their two major arguments have some prima facie problems. One argument holds that temporarily freezing the debt could have a salutary effect on investors, reassuring them of U.S. fiscal responsibility. However, it’s difficult to argue that nothing says an entity is “responsible about paying debts” as having the entity defaulting on them. The second common assertion runs along this line: “Might that not actually induce investors to buy long-term U.S. debt — reducing long-term interest rates and improving the U.S. investment climate?” [BusInsider] Current yields are already low — so why would lowering them even further get the players back in the government bond market? Even still, why would the government want to induce more sales of Treasuries, IF the conservative argument is correct and public debt tends to reduce money available for private or corporate bond indebtedness?
The Politicians
Whatever predilections might be held by House Speaker John Boehner concerning raising the debt ceiling, [Forbes] it is reasonably clear that the battle in the House of Representatives isn’t about the debt ceiling or the country’s economic health. [EPI] It has devolved into a fight over ideological and political budget priorities. This really ought to be a fight for another time, but perhaps someone’s focus group said that arguing that a debt ceiling must not be raised before spending is cut would make nice sound bites in campaign commercials.
Senator Heller seemed to be in the midst of that fight six days ago:
“I think they’re aggressively looking at $4 trillion, and that’s OK, because that’s a good short-term start,” Heller said. A reduction of $4 trillion is the largest-size plan on the table right now, and Republican House leaders have said it’s likely an impossible deal, because they, like Heller, don’t want to raise taxes, although some tax hikes are likely necessary, most economists agree, to achieve the sort of deficit reduction lawmakers have in mind without making draconian cuts to social spending.” [LV Sun]
Senator Heller has also joined the voices calling for a “balanced budget amendment” as part of any government financial restructuring. And, he’s serious about not raising any revenues: “Make no mistake; the President’s tax plan will hurt Nevada. Just as massive government spending has not helped create jobs, neither will massive tax increases. Washington has a spending problem, not a revenue problem.” [StateColumn]
A politician calling for a balanced budget amendment, advocating drastic spending cuts in the federal budget, and refusing to discuss any increases in federal revenues sounds very similar to those adhering to the “Cut, Cap, and Balance” cult in Washington, D.C. — or “Duck, Dodge, and Dismantle.”
All this might be an amusing exercise in semantics were it not for the fact that toying with the nation’s credit rating, and possibly defaulting on its bond holders, has some obvious and painful ramifications, not matter how lightly a politician might describe it:
- The cost of short term borrowing increases.
- Commodity prices, including oil, increase as investors move to “safe haven” investments. This could easily place more inflationary pressure on industrial nations like China and Brazil.
- The cost of consumer credit increases, including mortgage rates, student loans, automobile loans, and credit cards.
- The cost of credit default swaps on corporate bonds would increase making private sector borrowing more expensive. This would obviously curtail corporate expansion and thus further restrict JOB growth.
- Pension funds and other entities which are required by law to purchase only AAA rated bonds would be hurt.
- … and the people making some real money out of this mess are those who will get their commissions for selling derivatives based on U.S. Treasuries no matter what happens.
Yes, I think we could say a default would be “largely detrimental.” Now, what might Senator Heller DO to see that this doesn’t happen?
Meanwhile, back in the economy — what would really reduce the deficit would be tax revenues coming in from people who are not now working and therefore not paying income or payroll taxes. But, that would require talking about JOBS instead of attending the Multi-Ringed Washington Circus of Distraction.
Desert Beacon 
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