US default fears spark liquidity warning; America cannot live so carelessly forever; Playing Russian roulette is never advisable. Congress may find a bullet in the chamber this time

October 7, 2013 7:37 pm

US default fears spark liquidity warning

By Gina Chon and Stephanie Kirchgaessner in Washington and Michael MacKenzie in New York

Financial firms trading in US Treasury securities are preparing contingency plans in the event of a debt default, as experts warn that such a scenario could result in a catastrophic liquidity drain. “This would be an unprecedented event and the consequences for the market are dangerously unpredictable,” says Rob Toomey, associate general counsel at Sifma, a lobby group representing hundreds of securities firms, banks and asset managers that has drawn up plans for a coordinated strategy. “I think all the work in the world will not save us from uncertainty.”Sifma said it was talking its members through different possible scenarios for Treasury securities if the US Congress and the White House failed to increase the debt limit by October 17. Treasury secretary Jack Lewhas said the US will run out of cash to pay its bills, with the US having roughly $30bn in cash on hand.

Sifma warned that a default would have broad consequences since Treasury securities provide reference rates for other lending, including housing and corporate loans. Because Treasury securities end up in other financial instruments, missed payments by the US government could trigger defaults in certain kinds of municipal bonds or other escrow products, said Sifma president Ken Bentsen.

At the International Swaps and Derivatives Association, a committee has been meeting to discuss the issue of US government debt that is posted as collateral in over the counter transactions, which make up 4.6 per cent of the $2.5tn market. One of the topics being examined is whether parties would have a claim against the US government in the event of a default.

At Sifma, Mr Toomey said the key piece of information his members would be waiting for was an announcement from the Treasury about whether it could make a payment on a bill, note or bond that was due on a particular day. Treasury is expected to determine payments and postponements on a daily basis.

A $120bnTreasury bill is due to mature on October 17, and another $93bn bill matures on October 24, while Treasury faces principal and interest payments on several bills and notes on October 31. The various maturing bills include four-week, 13-week, 26-week and 52-week securities, according to Wrightson Icap data.

“The timing is key for the overall process because if [it is not paid], what happens to the security is that it essentially disappears,” Mr Toomey said. “Essentially the liquidity disappears from the market for that period of non-payment.”

This is how one scenario could play out in the aftermath of a default, if a bill was due on October 24:

Under normal circumstances the Fed Wire, the Federal Reserve transfer service for Treasury securities, would begin settling and processing daily transactions beginning around 7pm eastern time.

Sifma said it would be organising a series of calls beginning on October 23 in the hypothetical scenario, with the first call at 2pm eastern time with clearing banks and the Fed Wire to understand the situation and the status of key processing elements. There would be additional calls at 6:30pm, 8pm and 10pm.

If Treasury announced that it was going to extend the maturity of the bill that was due from the 24th to the 25th, the financial systems would be able to adjust accordingly.

But if the Treasury failed to make a payment and that was not known in a timely manner, such as after 10pm, it could result in the inability to transfer the security after that payment was missed the next day. Treasury securities that drop off the clearing systems also cannot be financed through the repurchase market or posted as collateral.

“Our working assumption has been that pricing on other securities could decrease and if they do, there could be significant margin calls.” said Mr Toomey, whose organisation began contingency planning in 2011, the last time an increase in the debt ceiling was in doubt.

Lou Crandall, an economist at Wrightson Icap, said that, based on current projections, the Treasury would exhaust its cash and debt resources by October 31, although there was a small chance it did so a week earlier when bills are set to mature on October 24.

“The bills coming due on that day could turn out to be the first issues to be held hostage in the debt ceiling debate,” he said. “If Congress drags this out, anxiety levels will ratchet up quickly over the next couple of weeks.”

 

October 7, 2013 3:49 pm

America cannot live so carelessly forever

By Gideon Rachman

Playing Russian roulette is never advisable. Congress may find a bullet in the chamber this time

Watching the US budget crisis unfold, I was reminded of a famous passage inThe Great Gatsby. “They were careless people, Tom and Daisy,” wrote F Scott Fitzgerald, “they smashed up things, and creatures and then retreated back into their money or their vast carelessness or whatever it was that kept them together.”

Right now, the Republicans and Democrats in Washington are behaving like the Tom and Daisy of global politics – a warring couple, whose rows seem more likely to damage innocent bystanders than themselves. American politicians seem confident that their nation’s wealth and power allow them to get away with careless behaviour that would be swiftly punished in a weaker and poorer country.

History suggests that this complacency is justified. Congress has played Russian roulette with government shutdowns before – and the bullet chamber has always been empty. More broadly, the 50 years since the assassination of John F. Kennedy have thrown up repeated political melodramas – from Watergate to the impeachment of President Bill Clinton. Each time, many thought that the American system was unravelling. Yet, each time, the US bounced back. For while America’s political flaws are very visible, its economic and social strengths are too easily discounted.

By contrast, foreigners have sometimes paid a heavy price for careless behaviour in Washington. It is a standard, self-pitying complaint in Brussels that the crisis in the eurozone was triggered by the collapse of a US investment bank, Lehman Brothers. A large part of the rest of the world’s grim fascination with the budget crisis reflects the fear that if the US economy catches another cold, the rest of the world will get pneumonia. China has told the US not to imperil the value of its holdings of US Treasury bills and Christine Lagarde, head of the International Monetary Fund, has warned of the damage the crisis could do to the world economy. But such complaints are drowned out by self-interested bickering in Congress.

The sense that the US is prone to “careless” behaviour that puts others at risk extends to international politics. America paid a high price in lives lost and money wasted during the Iraq war. But the US has now gone home and lost interest.Iraq, meanwhile, is still in the grip of the terrible civil conflict that followed the overthrow of Saddam Hussein.

The current crisis evokes mixed reactions in foreigners. Many, like Ms Lagarde, know that the rest of the world could pay a heavy price for the folly in Washington – and genuinely long for the Americans to pull themselves together. America’s admirers wince at the sight of a nation that they hold up as a model, making itself look so bad. But among those that resent US global leadership, there is considerable schadenfreude at the sense that the Americans – who like to preach about democracy abroad – are making such a bad fist of democracy at home. The Chinese will also be delighted that America’s efforts to assert leadership in Asia at the Apec summit have been thwarted by the fact that President Barack Obama has had to pull out to attend to the crisis in Washington. As for Vladimir Putin, Russia’s president – who recently took to the pages of The New York Times to warn Americans against the dangers of believing themselves “exceptional” – he would doubtless take a certain pleasure, if the markets eventually told Americans that they were not so exceptional, after all.

Conversely, the fear for the likes of Mr Putin is that those careless Americans will get another free pass. For the fact is that the US is so important to the smooth functioning of the global economy that the rest of the world has a vested interest in overlooking reckless behaviour in Washington. The last time the US played fast and loose with the debt ceiling, in 2011, Standard & Poor’s downgraded its debt rating. At the time many commentators saw this as a historic turning point and predicted that America’s borrowing costs would soar. In reality borrowing costs stayed low. Tom and Daisy had got away with it, again.

However, the fact that America has repeatedly survived careless behaviour – and bounced back from crises – has bolstered the inward-looking complacency in Washington. That, in turn, seems to have persuaded US politicians that they can take ever greater risks with the nation’s finances. But repeated games of Russian roulette are never advisable. It is certainly possible that this time Congress will spin the chamber – and find that there really is a bullet in it.

If a compromise is reached before the US Treasury runs up against the debt ceiling on October 17, then this will probably just be a case of “crisis as usual”. But if America crashes through the debt barrier, things get serious. As Gavyn Davies argued last week, it seems marginally more likely that the Obama administration will drastically cut back on current expenditure rather than default on debt payments. Moving overnight to a balanced budget would be a form of immediate forced austerity of the kind that has caused deep recessions in countries such as Greece and Spain – as they too have struggled to balance their budgets.

The difference would be that US austerity would be caused not by the pressure of the markets, or the IMF – instead it would be a self-inflicted wound that caused huge damage to ordinary Americans and to the global economy. That really would be careless.