Unthinkable?

by Economist

BEN BERNANKE reckons it would be “a huge financial calamity”. Bond markets remain sanguine about a possible failure to raise America’s debt ceiling by August 2nd, and the subsequent potential for a technical default. But it pays to plan ahead, just in case the politicians lose the last of their marbles.

SIFMA, a trade group for large banks and fund managers, recently gathered members together to discuss issues like how to rewire their systems to pass IOUs rather than actual interest payments to investors, should a default occur. “It’s one of those Murphy’s Law things. If we do it, it won’t prove necessary. If we don’t, we’ll be scrambling like crazy with a day to go,” says one participant.

But the moneymen hardly have all the bases covered. “I really thought I understood this market, until I tried to map all of the possible consequences of a breakdown,” sighs a bond-market veteran. That is hardly surprising, given that Treasury prices are used as the reference rate for most other credit markets. Moreover, some $4 trillion of Treasury debt—nearly half of the total—is used as collateral in futures, over-the-counter derivatives and the repurchase (repo) markets, a crucial source of short-term loans for financial firms, according to analysts at JPMorgan Chase.

Some fear that a default could cause a 2008-style crunch in repo markets, with the raising of “haircuts” on Treasuries leading to margin calls. The reality would be more complicated. For one thing, it’s not clear that there is a viable alternative as the “risk-free” benchmark. One banker jokes that AAA-rated Johnson & Johnson is “not quite as liquid”. In a flight to safety triggered by a default, much of the money bailing out of risky assets could end up in Treasury debt. Increased demand for collateral to secure loans could even push up its price.

Then there is the impact of a ratings downgrade. Money-market funds, which hold $684 billion of government and agency securities, are allowed to hold government paper that has been downgraded a notch. Other investors, such as some insurers, can only hold top-rated securities but their investment boards are likely to approve requests to rewrite their covenants, especially if a lower rating looks temporary. “It would be a full-employment act for lawyers,” says Lou Crandall of Wrightson ICAP, a research firm. There’s a surprise.

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