Recommended Reading Roundup: Faults and Defaults

CrashThere are some conservatives who have taken to calling a breach of the U.S. debt limit a “serious, but not all that serious” potential problem. They’re wrong.

One of the best general articles explaining the consequences of a default on the banking sector comes from Karen Brettell, writing for Reuters News.  Her article includes not only the  consequences for U.S. Treasuries, but money market accounts as well.  Hint: Money markets cannot hold defaulted collateral.  If you are wondering why that’s important — Money markets hold about $1.3 trillion in one of a couple of forms (1) government securities, and (2) repo loans they’ve made  made using government securities as collateral.  If a person wanted to be more precise, the full name of a repo loan when it’s at home is a Repurchase Agreement.  These “repo loans” are made to raise short term capital.  Repurchase agreements work like this:

Repo Loans are: A form of short-term borrowing for dealers in government securities. The dealer sells the government securities to investors, usually on an overnight basis, and buys them back the following day. For the party selling the security (and agreeing to repurchase it in the future) it is a repo; for the party on the other end of the transaction, (buying the security and agreeing to sell in the future) it is a reverse repurchase agreement. [Investopedia]

Now, after reading the Reuter’s article, take a look at RepoWatch’s post on what the rating agency Fitch has to say about the three big threats to the Repo/Money Market from a possible default.  Why worry? Because there are three major forms of short term investment in this country: Savings accounts, Money market funds, and CDs.  Nothing like kicking one leg off the short term investment stool, and then expecting it to stay upright?

I’ll keep saying this until someone can convince me otherwise:  Any politician who doesn’t understand the term “Risk Premium” AKA “Default Premium” has no business talking about a default being a tool to bargain for lower government spending.  So, the next highly recommended article is by economist Jared Bernstein, writing for the New York Times. You can’t say why  a default is dangerous any more simply than this:

“Why?  Because I believe — and again, I’m far from sure about this — the costs of default are large enough to wake up the grown-ups.  Interest rates would soar and not just on government debt but on all the securities out there that are tied to Treasuries.  Even with just the shutdown, we’re already seeing short-term lenders to the Treasury demand a risk premium: there’s been a mini-spike in the yields on one-month T-bills. Our stock of national debt is $12 trillion.  That means a 1-percent risk premium raises debt service by $120 billion.”

Again, from Investopedia, a risk or default premium is defined as:

“The additional amount a borrower must pay to compensate the lender for assuming default risk. A default premium is generally paid by all companies or borrowers indirectly, through the rate at which they must repay their obligation.”

And, there we have it. Should the U.S. default, even temporarily, on its obligations the financial sector will factor in a higher risk premium and a 1% increase in that premium will cost U.S. taxpayers another $120 billion in debt service.  It is impossible to “curb government spending” and default at the same time.  One or the other — pick one — because there’s no way to have both.

There are some other sources of information, and from the conservative side there’s the “Gee Whiz The US Won’t Miss Any Payments” argument from Forbes Magazine.  Evidently, the author assumes that if no payments are missed there will be no factoring in of an increased default or risk premium — that’s an assumption, not a fact. (And, one not substantiated by the 1979 experience discussed below.)

After complaining about the lack of “numbers” because the Administration is just being being a Green Meanie, the author has another out of hand dismissal saying that even though the Treasury has no way to prioritize payments, it’s “doable.”  On what planet is left to our imaginations.   However, don’t stop reading after the first “talking points” paragraph, because the author does describe the financial positions of major U.S. banks in regard to the holding of our public debt.   Let’s play with that “Gee Whiz” argument for a moment.

The government will, indeed, have revenues being taken in, and yes, these could be used to cover debt service. So, all will be well and rosy?  Not. So. Fast.

This is yet another demonstration that running the federal government is NOT like operating with a family’s household budget.

“Normally the way things work is that the Treasury Department cuts the checks Congress has told it to cut, collects the taxes Congress has told it to collect, and borrows to cover the difference. But the statutory debt ceiling also instructs Treasury not to borrow more than a certain amount of money. When we hit the debt ceiling on Oct. 17, Treasury will lack the legal authority to borrow any more money to close the gap between spending and tax revenue.” [Yglesias] (emphasis added)

The “it’s doable” argument offered by the Forbe’s article ignores the structural reality of our financial operations.  To better understand this go to Matthew Yglesias’s contribution to Slate.  Yglesias, in turn, refers to a Financial Times article (subscription required) with this core statement:

    “The Treasury’s systems do not clearly mark what scheduled payments are for what reasons, so it is impractical to try to prioritize payments. And clearing systems like Fedwire do not allow defaulted securities to flow, so the system would seize. In order for the clearing systems to work, the Treasury would need to notify the market of a default almost a day before the default happened (to give everyone time to modify payments), and that is not going to happen because the Treasury will not want to declare default while Congress still has time to pass a bill.   Also the Fed does not take defaulted securities as collateral at the discount window, even if those securities are still trading at par.”

In short, what the dreamers would have us believe is that the Treasury can (1) take action before a default having no precedent whatsoever to guide it, on (2) a prioritization scheme it has not pre-determined, nor has Congress legislated, and (3) do all this before the defaulted securities jam up the Fedwire, and all the institutional investors and pension funds which do not allow investment in defaulted securities.

And that’s DO-ABLE??  Not if we look at what that “Fedwire” does:

“The Federal Reserve Banks provide the Fedwire Funds Service, a real-time gross settlement system that enables participants to initiate funds transfer that are immediate, final, and irrevocable once processed. Depository institutions and certain other financial institutions that hold an account with a Federal Reserve Bank are eligible to participate in the Fedwire Funds Services.” [FedRes] (emphasis added)

There’s a reason we don’t have a “prioritization” scheme.  It’s quite simply because NO ONE EVER SERIOUSLY THOUGHT THE UNITED STATES GOVERNMENT WOULD DEFAULT ON ITS DEBTS — EVER.  So, are we to happily assume that all those Fedwire transactions will be in real time, immediate, final and irrevocable — while the Treasury Department figures out who gets paid in the gap between what has been taken in as revenue and what is owed to our investors?

“But!” Cry a few voices — the U.S. had a “default” in 1979 and it didn’t really hurt us — again, not. so. fast.  First, remember that even the threat of a default a couple of years ago toppled our AAA credit rating, and that 1979 glitch caused a spike of 60 basis points (0.6%) that lasted for about six months, and was rolled into all manner of related financial transactions.  [CBS, Barrons] The current situation is such that we aren’t talking about a small 1979 style glitch in the works — but a full on default.   There’s another myth gathering momentum in chain e-mails: “The U.S. has defaulted FOUR times! And we’re still here so what’s the big deal?”

Fact checking time — The first was 1790 in the “Funding Act” when the U.S. government absorbed the debts from the Revolutionary War — this was the reverse of a default! The U.S. didn’t default on debts it picked them up to make sure creditors were paid.  Then the e-mail artistes cite 1841-42 (all state defaults, the federal government wasn’t involved), and 1873-1884 (again, all states and local governments, with no federal involvement). Finally, there’s the 1933 currency law — which was more like monetizing our national debt than defaulting on it.  [More at CNBC] We can’t honestly add in the 1979 “computer glitch + short term investor stampede,” because there was no declaration of a default by Congress, or anyone else for that matter.

Therefore, the uninformed attempting to assert that the Debt Ceiling isn’t a really big no good horrible problem — (1) Did not pass Economics 101, or possibly High School General Business; (2) Has not taken a Finance 101 course, or slept through it in its entirety; or (3) Lives in a Wonderland in which nothing bad happens to assault the hypothetical underpinnings of their ideological visions… or (4) All of the above?  For the informed, the economists who dismiss the severity of the situation, they need to stop bemoaning the Ivory Towers in which some of their liberal arts colleagues are supposed to live, and climb down out of their own.

There are some other articles, not in this Highly Recommended List, but which help explain the reasons the financial sector is not enamored of a debt ceiling debacle — “The Battle In Congress on Spending and Debt,” New York Times.   “Will the U.S. default?” Barrons.  “Treasury warns of Debt Ceiling Crisis Economic Impact,” Time.

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