From Debt Crisis to Investor Panic

Even if the US technically runs out of money, creditors will probably allow a little time before calling it a default. But investors may bail long before then. Here’s a road map to how it would play out.

The United States inches closer to a default on its debts and a downgrade of its AAA credit rating.

Talks collapsed on Friday, and ended after less than an hour on Saturday. The “new” plans floated on Sunday are really old plans that deserve a place among the walking dead.

But what does default mean, exactly? As the Greek debt crisis and the “solution” to that crisis show, very little about this process is cut and dried. And stuff that seems like it should be definite—like the term “default” itself—is actually very, very squishy.

Turns out one of the big uncertainties is how long words—which make up what I’d call the “delay and deny" defense—can keep creditors at bay once you’ve run out of money and borrowing room.

Here’s how a US default would play out.

The Phone Call
If Congress doesn’t raise the debt ceiling, the default process will begin with a phone call, sometime on or after August 2.

The Federal Reserve will phone the US Treasury and say something like, “Projecting the inflows and outflows to the Treasury’s account, the account will be overdrawn by the end of the day. Do you want to deposit more funds, or cancel some of the scheduled payments?”

This part of the process is clear-cut. The Fed is required by law to make this phone call, and by law has no wiggle room. The Fed isn’t allowed to let the Treasury overdraw its account.

What happens next, though, isn’t nearly as clear. And what the Treasury might do if it gets that call has as much to do with politics as it does with government finances.

The Treasury isn’t talking about what it might do, at least partly because the last thing the Obama administration wants to do is tell Congress it might have more time to avert a disaster. My best guess: if the Treasury’s judgment is that buying Congress a few extra days will result in a deal that avoids default, the Treasury will find a trick, or two, or three—such as borrowing from Fannie Mae or Freddie Mac—to avoid a default.

If the politics say that a few days won’t matter, and that ratcheting up the pressure on Congress by holding back on issuing government checks or delaying payments due to vendors is more important, then the Treasury will start to practice triage on the government’s obligations.

Would that be a default? As you and I understand the word, definitely.

The US would owe money to bondholders, or Social Security recipients, or state governments, or military personnel, or vendors that sold it everything from computers to light bulbs, and it won’t be sending out payments on time. It has an obligation to pay, and it wouldn’t be living up to that obligation.

But the reality is that a borrower isn’t in default until a lender, creditor, or credit-rating agency says he or she is. And it’s frequently in the self-interest of the lending party or creditor not to call a default a default immediately.

NEXT: The Greek Example

The Greek Example
You can see that in the Greek crisis, where the solution patched together last week—requiring bondholders to roll over bonds that are maturing into new bonds with longer maturities—actually is a default.

Bondholders would not be getting the payments and the return of capital guaranteed to them by their original investment. The debtor has acted, by forcing that rollover, to delay the repayment of capital. And that’s a default on the terms of the original debt.

But there’s a big incentive for creditors and lenders to call a default something other than a default. Calling the Greek default a default, for example, might well trigger all the credit-default swaps and force sellers of that “insurance” in the derivatives market to pay up.

(You might think that being able to collect on the insurance you’ve paid premiums to put in place would be attractive to those who bought the insurance, except that lots and lots of buyers are also sellers and no one is quite sure how the buying and selling would net out—especially if some sellers were found to owe more than they could pay.)

Banks, national central banks, and the European Central Bank don’t want to call a default a default either, because that would destroy the value of collateral throughout the banking system. It would require central banks and national governments to find the money to capitalize banks that have, so far, funded themselves by borrowing against Greek government bonds.

Politicians certainly don’t want to call a default a default, because they’d be forced to go to taxpayers for the money to recapitalize affected banks.

Moody’s hasn’t said Greece is in default yet, but says it is inevitable and has downgraded debt again. Fitch Ratings is calling it a “restricted default event,” and Standard & Poor’s is likely to take similar action. That will allow Greek creditors such as the European Central Bank pretend that a default isn’t really a default, and continue to lend money to Greek banks with Greek government debt as collateral.

The argument, flimsy as it is, for not calling this default a default and for not treating Greek government debt as defaulted debt is that the default won’t last for very long (maybe), and will be cleared up (possibly) as soon as the full rescue plan is in place.

I think we can expect something similar for the US if Congress fails to raise the debt ceiling—a self-interested combination of delay and deny.

NEXT: When Is it a Default?

When Is it a Default?
As long as the US default looks like it is going to be temporary, then the force of delay-and-deny should hold out.

If the default stretches from days to weeks, however, delay-and-deny will gradually lose its power. More than a couple of weeks, I’d estimate, and delay-and-deny could be looking at a rout.

And it’s the bond market that’s likely to call time in any post-default crisis.

The financial markets really don’t want to call a US default a default. The credit-default swap market will initially vote that August 2 doesn’t constitute a credit event that would trigger payments from sellers to buyers of credit insurance.

Institutional investors—including money-market mutual funds, pension funds, and insurance—have surveyed their boards to see if a temporary default would trigger their rules on the credit quality of their portfolios. From the reports I’ve seen, most boards have said that a temporary default wouldn’t require portfolio managers to sell their holdings of Treasuries.

Overseas central banks and sovereign wealth funds don’t especially want to start selling their vast holdings of Treasuries, because any significant selling will set off a drop in the value of the rest of the Treasurys in these portfolios. (That’s especially true because the turmoil in the euro market makes assets denominated in that currency an underwhelming alternative to Treasuries.)
The repo, or repurchase markets—which use Treasuries as collateral for about 40% of what are, in effect, short-term loans—don’t want to issue margin calls on trillions of dollars of these loans, and risk a replay of Lehman Brothers and the global financial crisis.

But while the self-interest of the markets as a whole calls for looking past a US default, and calling it something else, the self-interest of individual players in these markets calls for getting out sooner rather than later. If you think the let’s-not-call-it-a-default is going to turn into a debt-market rout sometime after August 2, you want to be the first out the door, rather than get caught in a later stampede.

So the United States has time, but not very much time, before a default is a default is a default, as Gertrude Stein might have put it.

How Much Time?
That depends on the how slowly the bond market sells off US Treasuries in Asia and the United States.

Selling that looks like it will accelerate into a rapid rise in yields and a quick drop in bond prices will quite possibly put intolerable pressure on the delay-and-deny defense. No portfolio manager, no matter what his board has said, wants to be accused of waiting too long to move.

And every portfolio manager will be watching this week to see if the herd starts to break for the exits. The slightest whiff of “abandon ship” could easily become a self-fulfilling prophecy.

The US debt markets are lucky that the European debt crisis is still enough of a danger that the dollar and Treasuries have some allure as safe-haven investments. (Granted, that allure diminishes by the hour.)

Any squabbling in Europe or sign that the Greek deal is coming apart as the parties try to work out the details will mean a little more strength for the dollar, and a little more time for delay and deny.

On the minus side, well, there’s Congress. After the collapse of talks Friday and the truncated meeting Saturday, Sunday brought a raft of proposals that were dead on arrival…

• The Republicans keep offering packages of cuts that Democrats won’t accept—especially because they have a very strong suspicion that none of these offers would get through the Republican-controlled (and I use the term “controlled” very loosely) House of Representatives.
• On the Democratic side, President Barack Obama faces a near insurgency in his own party that threatens to turn into outright rebellion if he accepts a deal with budget cuts and no revenue increases. Yet anything with revenue increases is almost certainly dead on arrival in the House.

If Standard & Poor’s and the bond market look at this wreck and see no chance of avoiding a default, the deny-and-delay defense will take a major blow. That’s why the cockamamie Reid-McConnell plan, which would allow Obama to approve an increase in the debt ceiling while letting congressional Republicans vote against any increase, is surprisingly pivotal.

As convoluted as that plan is—and as dependent as it is on arcane rules of Congress, rather than on anything that approaches a democratic process—it is the only plan on the table right now with a legitimate, if not especially large, chance at success.

If that plan dies, and there’s nothing viable to replace it to give deny-and-delay some degree of plausibility, then it won’t matter whether anyone calls this default a default or a “short-term credit disruption.” The bond markets will speak, bond investors will run for the exits, and the US default will be real.

Full disclosure: I don’t own shares of any of the companies mentioned in this column in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this column. For a full list of the stocks in the fund as of the end of March, see the fund’s portfolio here.