Thursday, October 3, 2013

Investment Implications Of A Government Default

Should you google “debt ceiling default” or its variants, you will discover a substantial literature on the subject. Four sources are particularly interesting.* These publications are quite alarming:
“Let us be perfectly clear: crossing the debt ceiling would be catastrophic.”
NY Magazine: 
“Economists and policy experts agree that reaching the X Date
could be the start of financial Armageddon...We don't really know what happens if Treasury bonds default, since it's never happened. What we do know is that it would destroy the market as we know it.”

US Treasury:

"A default would be unprecedented and has the potential to be catastrophic: credit markets could freeze,the value of the dollar could plummet, U.S. interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse."

Among the risks cited are:

1. A flight from Treasuries

The thinking here is that, once Treasuries lose their “risk free status”, portfolio adjustments will inevitably ensue. Many investors are not permitted to hold defaulted securities, but cannot discriminate between the defaulted and the undefaulted securities of the same issuer.

2. Disruption of the money market

The Fedwire will not accept defaulted securities, and cannot discriminate between defaulted and nondefaulted securities of the same issuer. Thus, it is conceivable that the Fedwire will not be able to accept any Treasury securities.

3. Disruption at the discount window

Here again, the Fed cannot accept defaulted collateral, but is unable to discriminate between defaulted and undefaulted securities of the same issuer.

4. Loss of reserve currency status
The global perception of the Treasury as a risk free security would be jeopardized by a default, leading to a move out of dollar assets.

5. Ratings downgrades
Rating agencies will react adversely to a default, as they have already cited it as a risk factor.

Let me address these risks in turn:

1. Flight from Treasuries
This is far-fetched. Treasury prices are rising. There is no change in the creditworthiness of the United States. Insofar as anyone is forced to sell, there will be plenty of investors who would be happy to buy Treasuries at a discount. The Treasury market is infinitely efficient.

2. Market disruption
This strikes me as quite likely, given the reasons cited above. A Treasury default would necessitate some extraordinary actions on the part of both the Fed and portfolio managers (and perhaps their clients), which I think would be readily accepted by the market. The simplest fix would be to ignore the defaulted status of Treasuries altogether, since they remain risk-free even in default (aside from the timeliness issue).

3. Loss of reserve currency status
This is a long shot. The factors supporting the dollar as a reserve currency and the Treasuries as reserve assets are unaffected by this event, and the factors weighing against JGBs and Bunds remain.

4. Rating downgrades
Reading the tea leaves, I doubt it. S&P has already downgraded the US to AA+ in part because of this risk. Moody’s did not downgrade the US, and recently changed the rating outlook from negative to stable, citing the declining deficit. I think that S&P would feel that its downgrade was justified by the default, and that Moody’s would not reverse itself because of an event unrelated to underlying creditworthiness. There is no doubt in my mind that a post-default US would remain a AAA credit in both a cardinal and ordinal sense, and that the market’s opinion of the US as a credit would not change either. A technical default is not a credit event. (If a gold mine shuts down for a week, it is still a gold mine.)

With respect to the stock market, I would expect a selloff of a few hundred Dow points in the event of a default. I would view such a selloff as irrational and an opportunity to buy stocks at a discount. I am overweight equities, and I intend to remain so. If there is a default-induced dip, I plan to buy into it.

The best modern analogues are Y2K and 9/11. Y2K was an anticipated financial disaster that didn’t happen. Had it happened, it would have been an example of a noneconomic event with financial implications. Similarly, the U.S. capital market shut down on 9/11, due to mechanical disruption in the Financial District. Bond and stock trading ceased while Wall Street struggled to restore power and communications. The market didn’t do well after it reopened, but I think that was due to the breaking Enron story, which shook the credit markets to a much greater extent than 9/11. 9/11 was a black swan that could be absorbed, whereas Enron was a black swan that shattered market confidence.

*1. “Here are Some of the Apocalyptic Things That Could Happen If the Debt Ceiling is Breached”, NY Magazine:

3. “Debt Ceiling Analysis” by the Bipartisan Policy Center:
4. "Macroeconomic Implications Of Debt Ceiling Brinkmanship", US Treasury:

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