Thursday, October 3, 2013

The Debt Ceiling Is Not Lehman

“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.”

--US Treasury, Oct. 2nd, 2013

Yesterday, the Treasury published a paper, “Macroeconomic Effects Of Debt Ceiling Brinkmanship” which lays out the consequences of a government default.  Here are the paper’s assertions:
1. Credit markets could freeze;
2. The dollar could plummet;
3. Interest rates could skyrocket;
4. There could be a financial crisis similar to 2008.

I understand the Treasury’s motivation in publishing this paper. It is the Treasury’s job to protect the credit of the US, and to maintain the Treasury as the gold standard of global credit risk. If I were Secretary of the Treasury, I would publish a paper exactly like this. There is absolutely no reason to run such a dangerous experiment to see if it is survivable. The Republican party is not, or should not be, a bunch of drunken rednecks lighting a match and saying “Watch this!”. Only a reckless fool would allow the US to default, and I trust that Speaker Boehner is not a reckless fool like Ted Cruz and his ilk.

However, as investors we must prepare for any eventuality, including a government default. In yesterday’s post I addressed the first three risk factors above, and concluded that the credit markets would stay open, the dollar would not plummet, and interest rates would not skyrocket.

Today I will address Point Four: the risk of another financial crisis like 2008. That assertion is just preposterous. It could only be suggested by someone who has already forgotten what happened in 2008. Permit me to refresh Jacob Lew’s memory about 2008.

This is what happened then:
1. Overnight, $2 trillion of subprime mortgage-related securities went from being zero risk to being toxic, opaque and of unknowable value.
2. No one knew who was exposed to what securities in what amount.
3. The FASB, at that very moment, chose to change the accounting treatment for such securities from mark-to-model to mark-to-market, just as the market disappeared.
4. In the midst of a crisis in which no counterparty could be sure of another, the Treasury allowed a $700 billion financial institution to go bankrupt, which completely blindsided the markets.
5. The credit markets froze solid because (a) no one knew who was solvent; (b) no one knew who was or wasn’t TBTF; and ( c ) credit committees decided that, given the level of uncertainty, they would only take good names irrespective of the quality of collateral offered by the “question mark” names such as Goldman and Morgan Stanley.
Hence the crisis and hence the bailout.

This scenario is not remotely analogous to a debt ceiling problem:

1. No large asset class will go from being riskless to being risky. This is not a credit event.
2. No one will care who is exposed to defaulted Treasuries because they will be worth 100 cents on the dollar. No one will be rendered insolvent (except maybe some naked ultra-shorts).
3. Treasuries are already carried at market, so the accounting won’t change.
4. No systemically-significant financial institution will fail because of a government default.
5. Counterparty credit lines will remain open because nothing material will have happened.

That’s my view. I don’t buy the Armageddon talk. I don’t see a breach of the debt ceiling as a meaningful economic event, any more than Y2K might have been. Markets can handle events when there is adequate certainty about the implications for all participants. A government debt default would be survivable, like a dirty bomb or another 9/11.

I can’t bring myself to believe that anyone could be so stupid as to run this experiment as a form of political theater. But then again, it never occurred to me that Paulson-Geithner-Bernanke would let Lehman go either. So we must force ourselves to think through such an eventuality. I am staying overweight in US equities.

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