Wall Street digs in for a debt default; Traders are talking about the prospects of “dirty prices” and other default oddities

Wall Street digs in for a debt default

By Stephen Gandel, senior editor October 4, 2013: 9:49 AM ET

Traders are talking about the prospects of “dirty prices” and other default oddities.

FORTUNE — On Thursday, the Treasury Department released a report anticipating what would happen if we have a debt ceiling default. One prediction: a financial crisis that could “echo the events of 2008 or even worse.” It’s hard to see exactly how that could happen. If Treasury bonds were to plummet after a debt default, that could cause other bonds to drop in value as well, creating big losses for the banks — and perhaps putting them in jeopardy. But banks have been anticipating a jump in rates for a while. Many banks have already shown investors what would happen if rates suddenly rose three percentage points, which is a big jump. It’s not pretty, but no bank appeared to be in jeopardy.What’s more, Treasury bonds might not actually drop in value after a debt default, or at least not much. In fact, they could rise in price. If everyone assumes that Uncle Sam will eventually pay, traders say the market could switch to so-called dirty prices. Under that scenario, Treasury bonds would rise in value to compensate holders for the interest they are not getting paid, but everyone assumes eventually will.

The Treasury’s report lacked any details on just how the U.S. government missing some bond payments would end up causing JPMorgan Chase (JPM) to fail. (This is just an example. Treasury didn’t name names.)  A Treasury spokesperson declined to comment further on the report. A Federal Reserve spokesperson decline to comment on whether it was doing anything to make sure banks were ready for a debt-ceiling-induced financial crisis.

But clearly some on Wall Street are concerned. On Wednesday afternoon, a regularly scheduled conference call of Wall Street’s major Treasury dealers turned into a impromptu default planning session. On the call, which had about 40 people including representatives from Citigroup (C), Goldman Sachs (GS), Morgan Stanley (MS), and other major foreign and U.S. banks, traders complained that they were getting little feedback from either Treasury or the Federal Reserve about how a default might work or if the agencies had drawn up any of their own contingency plans. “The conclusion was we needed to tell regulators as a group that a default would be really disruptive to the marketplace,” says a person who was on the call.

DTCC, which is Wall Street’s largest clearinghouse for stock and bond trades, said it was making sure it would be able to process trades if some Treasury bonds defaulted. “We continue to monitor the potential debt ceiling situation and, as part of our overall business contingency plans, are modeling a variety of scenarios,” says a DTCC spokeswoman.

Big banks are reportedly filling ATM machines with more cash than usual just in case depositors get nervous about their accounts. That’s something banks did back in 2011, the last time Washington nearly missed the deadline to raise the debt ceiling.

“I think it could be way, way worse than 2008,” says Jens Nordvig, who is a fixed income strategist at Nomura.

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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