The Threat of a Default

by Pejman Yousefzadeh on July 21, 2011

It’s already wreaking havoc:

Lawmakers in Washington are racing to reach a deal to save the country from defaulting on its debt, but on Wall Street, financial players are devising doomsday plans in case the clock runs out.

These companies are taking steps to reduce the risk of holding Treasury bonds or angling for ways to make profits from any possible upheaval. And even if a deal is reached in Washington, some in the industry fear that the dickering has already harmed the country’s market credibility.

On Wall Street, Treasuries function like a currency, and investors often use these bonds, which are supposed to be virtually fail-proof, as security deposits in their trading in the markets. Now, banks are sifting through their holdings and their customers’ holdings to determine if these security deposits will retain their value. In addition, mutual funds — which own billions of dollars in Treasuries — are working on presentations to persuade their boards that they can hold the bonds even if the government debt is downgraded. And hedge funds are stockpiling cash so they can buy up United States debt if other investors flee.

The rating agencies, which control the fateful decision of whether the nation deserves to have its credit standing downgraded, are surveying other entities that would be affected by a United States default — like insurance companies and states — and issuing warnings that a United States downgrade could result in several other ratings cuts. States that might be downgraded, in turn, are trying to reassure the market that they could still pay their bills on time.

All these contingency plans hinge on the pivotal date of Aug. 2, when the Obama administration has said it will no longer be able to finance government obligations without raising the $14.3 trillion cap on government borrowing. If lawmakers do not act before then, it will be difficult for the Treasury to meet coming interest payments as well as obligations to government employees, vendors and programs like Social Security and Medicare.

Even though many on Wall Street believe that a default remains unlikely, the financial markets are starting to become agitated. Volatility in stocks has soared, and some investors say stock prices are falling because a United States default could severely raise companies’ costs of doing business.

All of this chaos, of course, can be laid at the feet of a political class which is bound and determined to be grossly irresponsible at every turn. And one suspects that they have not yet had their fill of irresponsibility; there are, after all, 10 days as of this writing before the United States goes into default if a debt ceiling deal is not reached. Plenty of time for more lunatic actions to be designed and implemented so as to terrify the markets and market participants even more.

  • Johndoe

    We won’t go into default if the debt limit isn’t raised. All interest on debt can be paid with existing monthly revenues. All other obligations will have to be prioritized. That is not the definition of default.

    • Pejman Yousefzadeh

      Even if that is true–and I do not concede that it is–not paying certain bills will signal to creditors that we are no longer the entirely reliable payor that we have been in the past. That alone may be enough to raise interest rates, make borrowing for the United States government more expensive, and make borrowing for the American people more expensive since credit card rates, home loan rates, car loan rates, student loan rates, and any other loan rates you can think of are tied to Treasuries.

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