No Way U.S. Would Allow Debt Default? Don’t Bet on It

OCTOBER 7, 2013, 9:01 PM

No Way U.S. Would Allow Debt Default? Don’t Bet on It

By ANDREW ROSS SORKIN

“The United States government is not going to default, ever.” That’s what Vincent Reinhart, former head of the Federal Reserve’s monetary division and now managing director and chief United States economist for Morgan Stanley, said late last week. “As political theater,” he said, “the debt ceiling is not a useful threat, because politicians are basically threatening to shoot themselves, as they will rightly shoulder the blame for the serious global economic consequences of a default.”Mr. Reinhart’s view has become conventional wisdom on Wall Street when it comes to whether the country will hit the debt ceiling limit on Oct. 17. Warren Buffett put it this way: “We’ll go right up to the point of extreme idiocy, but we won’t cross it.”

Nobody believes the country will actually exceed the debt limit — which is exactly why it might.

Oddly enough, despite all the predictions of panic, the stock market was down only marginally over the last couple of sessions.

Here’s the perversity of Wall Street’s psychology: The more Wall Street is convinced that Washington will act rationally and raise the debt ceiling, most likely at the 11th hour, the less pressure there will be on lawmakers to reach an agreement. That will make it more likely a deal isn’t reached.

John Podesta, the former chief of staff for President Bill Clinton, said that while only weeks ago he thought it was almost impossible that Congress wouldn’t reach a deal, he now questions whether it will be reached in time.

What happens when the government exceeds the debt limit? It is often forgotten, but it actually did default once, in 1979 — but this was by accident.

Here’s a history lesson from Donald B. Marron of the Tax Policy Center: He wrote on his blog in 2011 — the last time this game of chicken was taking place — that Congress raised the debt ceiling at the 11th hour in 1979 but the government “defaulted because Treasury’s back office was on the fritz.” He explained that the government ultimately paid the debt back in full.

So what happened to interest rates? “T-bill rates rose almost 0.6 percentage points (i.e., 60 basis points). There’s no indication this increase reversed in the days that followed.” That may sound like a lot — and it is — but let’s put that in context: “T-bill rates hover near zero compared to the 9-10 percent range of the late-1970s; that means a temporary delay in payments would be less costly for creditors.”

Of course, for the last several weeks we have heard ad nauseam about how imperative it is for Congress to raise the debt ceiling or risk imperiling the creditworthiness of the United States. Even approaching the deadline without a resolution was supposed to send the market into a panic and interest rates skyrocketing.

And yet here we are, about a week before the deadline, and the market hasn’t cratered despite remarks over the weekend by House Speaker John A. Boehner, who indicated, for the first time, that he planned to use the debt ceiling as a negotiating chip in seeking concessions from President Obama, who has steadfastly refused to negotiate. “I told the president, there’s no way we’re going to pass one,” Mr. Boehner said. “The votes are not in the House to pass a clean debt limit. And the president is risking default by not having a conversation with us.”

Almost bizarrely, the market’s reaction — or lack of one in this case — may actually contribute to an outcome everyone has been railing against.

The ruinous potential for a default has had Wall Street leaders screaming from the rooftops: “Whatever circumstances and disagreements got us to this current unhappy juncture, there is no way that our government leaders can allow the full faith and credit of the United States of America to be jeopardized. This is an issue that affects every single citizen, from veterans to Social Security recipients to government bondholders to all taxpayers, and threatens to derail an already fragile economic recovery,” James P. Gorman, the chief executive of Morgan Stanley, said in an e-mail to his employees, urging them to contact their representatives in Washington.

Goldman Sachs put it this way: “A very short delay past the October deadline — for instance, a few days — could delay the payment of some obligations already incurred and would create instability in the financial markets.” He added, “This uncertainty alone could weigh on growth.”

For some market participants, the prospect of reaching the debt limit isn’t worrisome, not because they don’t think a deal will be reached but because — and I disagree with this — they believe that the Oct. 17 deadline is either fake — they speculate that Treasury Secretary Jacob J. Lew has built in some wiggle room to force a decision — or that the government would ultimately be able to prioritize certain payments over others so that it could continue to pay its debts and Social Security payments. Of course, the Treasury disputes that, saying it is impossible to prioritize the millions of payments that the government makes every day.

A year ago, Stanley F. Druckenmiller, the hedge fund manager, told The Wall Street Journal: “I think technical default would be horrible, but I don’t think it’s going to be the end of the world. It’s not going to be catastrophic. What’s going to be catastrophic is if we don’t solve the real problem.”

He is right about the need to solve the big problems. But unless we sit up and pay attention, we may create an even larger one.

Here’s The Horrific Stock Market Crash We Could Witness If The US Government Misses An Interest Payment

SAM RO OCT. 7, 2013, 10:19 AM 16,593 54

Congress has yet to address the impending U.S. debt ceiling, which will be hit on Oct. 17 if nothing is done.

Analysts believe that if the U.S. hits the debt ceiling and eventually defaults on its liabilities, then the resulting market chaos could actually cause investors to dump risk assets and rush into U.S. Treasury securities causing U.S. interest rates to fall.

One risky asset class they are sure to leave is the U.S. stock market.

Deutsche Bank sees a 0% chance that the U.S. debt ceiling debate gets to the point where the Treasury runs out of cash and starts missing interest payments.

“The S&P 500 likely drops to about 1650 if convincing signs of an imminent deal do not emerge by Friday, but not under 1625 as a deal should come before Treasury exhausts its funds,” wrote Deutsche Bank’s David Bianco in a note to clients. “A multi-week shutdown will drag on GDP, but 4Q GDP & EPS growth will still be decent. We see missed interest payment risk as nonexistent and would use any weakness next week to buy non-financials.”

But for the heck of it, Bianco runs the worst-case scenario.

Should the U.S. miss an interest payment, Bianco sees the S&P 500 crashing to 850.

Markets And The Debt Ceiling: This Time It’s Different

STEVEN PERLBERG AND SAM RO OCT. 7, 2013, 8:12 PM 6,195 29

The Oct. 17 U.S. debt ceiling deadline is quickly approaching. But markets have been largely unfazed by what many experts warn could be economic catastrophe.

The conventional wisdom has been that lawmakers understand the higher stakes of the debt ceiling and will surely prevent the country from self-inflicted economic trauma.

And considering the fiscal brinksmanship of recent years, it’s understandable why investors appear to be unusually complacent.

But are they being too complacent?

“This is anecdotal, so ultimately worthless — but I can’t help noticing that everyone saying shutdown/ceiling not a reason to sell stocks,” tweeted Matt Busigin on Sunday. “That is the opposite of what I saw during the last debt ceiling and government shutdown talks. Which may mean it’s not priced in, and untrue.”

“[Investors] believe that — as in the past — the fiscal showdown will end with a midnight compromise that avoids both default and a government shutdown,” warned Nouriel Roubini on Sept. 1. “But investors seem to underestimate how dysfunctional U.S. national politics has become. With a majority of the Republican Party on a jihad against government spending, fiscal explosions this autumn cannot be ruled out.”

As we now know, the government failed to avoid the shutdown.

The degree of investor complacency may be best captured in government-exposed stocks. In a recent report, Goldman Sachs’ Robert Boroujerdi noted “We estimate that little or no volatility premium for the debt ceiling debates is priced into the options markets on stocks most exposed to government spending cuts.”

“Complacency is even more pronounced on stocks with high government exposure,” he added. “Fear priced into options on these stocks dropped over the past few months to new lows vs. SPX options.”

As you can see in the chart above, the cost of put options — which protect investors from sell-offs — for government-exposed stocks recently fell to post-crisis lows. And this time period included at least four post-crisis budget bouts.

The message of complacency is less obvious when you look at the market as a whole. Today, the Volatility Index (VIX) jumped 15%. Still, it continues to be below recent highs. And the S&P 500 is just 2.8%  below its Sept. 18 all-time high.

“[W]e believe there is a zero percent chance of a federal government default at that time,” said Morgan Stanley’s Vincent Reinhart. “The U.S. government will pay its bills.”

In a note to clients on Friday, Deutsche Bank’s David Bianco wrote that he too saw a zero percent chance that the debt ceiling debate reaches the point where Treasury actually runs out of money and starts missing interest payments.

The language from Wall Street’s experts reflect absolute certainty that the U.S. will survive the ongoing debate over the debt ceiling.

However, “zero percent” is the type of language that should set off warning sirens.

Interestingly, Bianco estimated that should the zero-percent scenario occur, the S&P 500 could crash to 850, about a 50% drop.

What’s frightening about Bianco’s forecast is not the scale of the decline. Rather, what’s frightening is that he would go out of his way to present a scenario that had a “zero percent” chance of happening. Because zero represents an impossibility, in theory it couldn’t qualify as a worst-case.

If this really had a “zero percent” chance of happening, then there would be no need for Goldman Sachs to write:

If the debt limit is not raised before the Treasury depletes its cash balance, it could force the Treasury to rapidly eliminate the budget deficit to stay under the debt ceiling. We estimate that the fiscal pullback would amount to as much as 4.2% of GDP (annualized). The effect on quarterly growth rates (rather than levels) could be even greater. If this were allowed to occur, it could lead to a rapid downturn in economic activity if not reversed very quickly.

It seems pretty clear that complacency is unusually high, which makes us even more worried that we could have an accident in Washington.

Hopefully, this time isn’t different.

A closer look at the last four fiscal incidents show that “not all fiscal deadlines are created equal.” That was the message of Goldman Sachs’ Alec Phillips.

Fiscal issues aside, other “unknown unknown” events in American history have spurred market sell-offs. It took the Dow Jones Industrial Average 309 days to crawl back from its lows after Pearl Harbor.

And on the first trading day after 9/11, the DJIA fell 684 points, which set a record for biggest loss for one trading day. By the end of that week, the index was down 14.1%.

Recall that the stock market also lost half its value in the months following Lehman Brothers’ collapse, prompting a harrowing recession.

Of course, other seemingly monster moments in history — like the crisis at the Fukushima reactor — saw little movements in U.S. markets.

Economically speaking, failure to raise the debt ceiling could rival any of these events. It would of course be doubly silly since that failure would be entirely voluntary.